The Profitability of Active Stock Traders

By Garvey, Ryan; Murphy, Anthony | Journal of Applied Finance, Fall 2005 | Go to article overview

The Profitability of Active Stock Traders


Garvey, Ryan, Murphy, Anthony, Journal of Applied Finance


Active stock traders, or day traders, who may account for a sizable proportion of US trading volume, hold stocks for only hours or even minutes. Examination of their trading profits reveals that about half of the 1,386 day traders in this study were profitable after paying commissions. Both profitable and unprofitable traders have very similar trading characteristics; they concentrate their trading at much the same time, on the same stocks, and in the same trading locations. Yet the skilled or lucky traders generate $9.5 million in net intraday profits, and the unskilled or unlucky lost $4.6 million in the same three-month sample period.

[G10, G19]

Active traders or day traders differ from long-term investors in that they often hold stocks for minutes or hours, seldom overnight, closing out positions for small profits. Active traders account for a fairly sizable percentage of trading volume in US equities. A study by Bear Stearns finds that approximately 40% of US share volume originates from an estimated 30,000 day traders (Goldberg and Lupercio, 2004). To some, this is surprising, as Barber and Odean (2000) and others show that active trading reduces one's wealth. According to Barber and Odean, overconfidence is the main reason people actively trade.

Active traders are at information disadvantage to better informed market participants such as market makers. Large market-making firms, such as Knight Trading Group, can use order flow information to generate short-term trading profits (Ip, 2000), but individuals trading on their own account do not have this information.

While active traders face disadvantages from the onset, firms that cater to them continue to attract new customers (McGinn, 2003), and "brokerage firms are spending feverishly to attract and retain this lucrative segment of the market" (Patel, 2002).

Individuals engage in active trading strategies because they anticipate trading profitably. Whether they can generate consistent short-term trading profits remains an open question, and there is very little research examining the trading profits of retail day traders in the US. Harris and Schultz (1998) examine the trading profits of retail day traders before electronic communication networks (ECNs) became integrated into the national market system. They find that some day traders generated consistent trading profits under these conditions and that agency costs were the most likely reason.

Retail traders, who trade on their own account, have more of an incentive to trade profitably than market makers because they incur all their trading gains and losses. This incentive can allow retail traders to overcome their information disadvantage and achieve trading profits against the better informed market participants such as market makers.

Are there agency costs on market-making trading desks today? It is difficult to say. There have been significant market structure changes as well as advances in trading technology since the Harris and Schultz study. Moreover, most traders today, who work on behalf of market makers, are heavily compensated on their trading performance. Knight Securities, Nasdaq's largest market maker, compensates its traders solely on trading performance (Ip, 2000).

We examine the trading profits of US retail day traders in today's ECN trading environment and explain why some active traders generate consistent net trading profits under current market conditions. Approximately one-half of the day traders in our sample were profitable after paying commissions. Our results suggest that some traders are able to trade profitably because they form zero-sum games with similar type traders.

I. Dataset of Active Traders

To conduct the study, we obtain a unique transaction dataset from a popular US direct access broker and analyze the trading records. The direct access broker has clients throughout the United States. Clients trade at the firm's 23 branch offices or remotely from home. …

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