For decades now, brokerages have offered people around the world the ability to trade various financial instruments. As technology has advanced, more and more people have gained access to financial markets, and trading itself became available to everybody who had a smartphone and a few dollars in their pocket. Brokerage clients used to be the predominantly long-term investors. But in recent years, with the technology behind trading advancing rapidly, what used to be the prime territory of institutions became an obsession for simple folks around the world — people trading THE (not investing IN) financial markets. Be it stocks, commodities, index futures, currencies — buying or selling them for short term gains to make a fortune has become a fascination for millions of people around the world.
Once not long ago, individuals used to buy or sell financial instruments based on the fundamental belief that the price was over or underpriced. They would call themselves individual investors, and their market actions would usually involve holding a position for the long term and seeing it confirm or refute their reasoning over time. Warren Buffet is the most well-known and successful example of such an approach.
In recent years, however, buying and selling financial instruments has become dominated not by investors but traders. These people call themselves swing traders, position traders or day traders. They tend to go for short term reasoning behind the decision to buy or sell a specific stock, index, commodity or currency pair. The trades generated by those traders don’t have to be validated by a particular stock being good or bad to buy or sell it. In other words, they do not work with any fundamental economic long-term theory, reason or belief when entering a position. The traders hold their position for the short term, timing it with particular events, such as daily news, company earnings, interest rate announcements, or basing it on technical analysis.
Of course, the brokerages that allow folks to access financial markets (being A-book, B-book or hybrid) tend to like the new, emerging mass-market category of today’s traders. The simple reason behind this is that they generate more trades and, therefore, more fees, such as trade commissions and interest rate fees due to the leverage those brokerages provide. In other words, brokerages hand money to those traders to buy or sell more, earning interest rate fees from larger positions, as they can provide up to 100 times more leverage than the account balance of the trader. Another category of income for brokerages is market quote spreads they offer, often causing people to buy above or sell below the real market prices. Some may ask, why would people do that? Well, usually, they have no real choice. If a person has only a few hundred dollars to trade with, those brokerages will use that fact to lure the person in, promising massive leverage and getting fees from both sides of the aisle — commissions from larger trades, and fees from leverage — credit amounts to trade. In essence, brokerages sell to a person, or buy from him at a less attractive price than the market offers, to magnify the amount that person has to trade with — a win-win solution for brokerages and a lose-lose for average folks trying to get rich.
So, it comes as no surprise that the majority of individual traders out there lose. As stated above, the primary reasons for this include trade commissions, bigger market spreads and leverage-driven interest rate fees. So this brings us to the next logical question: How do the brokerages survive? Even with millions of individual traders out there, if the majority of them lose, how does this supply of new accounts not stop? The reality is somewhat sad: according to the research conducted by Berkley University in California, it takes five years for the consistently losing trader to quit trading. The way to think about this is to compare it to gambling, but of course in a game of skill environment. Billions of dollars are being lost daily by simple folks to more professional, institutional investors with an appropriate risk management policy who have access to more funds to trade, and of course, more advantageous conditions in terms of fees. Brokerages promise many things but deliver on few — and the majority of traders lose while brokerages take their money.
One more important thing should be said about the trader’s losses. We can’t blame online brokerages entirely for the fact that most traders lose. Research shows that despite all the unfavourable conditions mentioned above, about 60% of the total trades generated by individual traders are positive! So, on the surface, everything seems good. However, when we look at the remaining 40% of negative trades, we see that the average losses of negative trades are twice as large as the winning ones. To understand this phenomenon, we need to refer to the work of Nobel Prize winner Daniel Kahneman, interestingly enough, a scientist who graduated from my high school about 40 years ago. Daniel Kahneman was awarded the Nobel Memorial Prize in Economic Sciences for his groundbreaking work in applying psychological insights to economic theory, particularly in the areas of judgment and decision-making under uncertainty. According to Daniel Kahneman’s work, people make decisions based on the potential value of losses and gains rather than the actual outcome. In simple language: losses hurt more than gains feel good. So how does this relate to trader’s losses being twice as large as the wins on average, despite the total amount of trades being positive? The answer is simple — time. Traders tend to close winning trades much more quickly than losing trades, and the stats show traders holding losing trades for a much longer time than the winning ones. In other words, without a strict discipline that limits any emotional decision behind the trading strategy, traders tend to lose over time.
So, it seems traders face a significant mountain to climb to be successful — unfavourable trading conditions stipulated by online brokerages and psychological barriers. How can we stop this vicious cycle? How can we help millions of simple folks stop losing as much as they do today? One of the answers may come with risk management analysts being replaced by machines able to predict traders performance, and not just for hedge funds on the back end to create a trading strategy using retail trading data, but also for retail traders to have access to such trading data.
