Move over Albert Einstein. Day-traders have their own theory of relativity. Long-term investments? To a day-trader that may mean hours, or more likely minutes. This might not seem very long-term for individuals schooled in the notion that investors should look for companies whose future prospects look promising, buy shares, hold them, and watch them grow year after year. But everything’s relative.
Not long ago (before online trading became the rage) day trading was the province of a handful of securities professionals. Back in the last century (if readers can recall the mid-1990’s) access to real-time quotations was limited, and prohibitively expensive for the amateur. Investors relied upon brokers for quotes and trade executions, and few individuals gave up their day jobs to sit by computers and monitor bid and ask prices.
The world has changed of course. Day-trading has become a fixture of American culture, and professional day traders have given way to legions of amateurs dedicated to turning their dreams into riches, one share at a time. Students, stay-at-home moms, the unemployed, the retired and senior citizens have joined this parade. Two centuries ago, men left their homes, families and jobs and moved west in search of gold. Today they remain closer to home, but the goal is still the same – thar’s gold in them there stocks. All it takes is a computer and a dream.
And the regulators are worried. What has them concerned? As SEC Chairman Arthur Levitt told the U.S. Senate, day-trading "is neither illegal nor is it unethical. But it is highly risky." Moreover, there appears to be an effort on the part of some day-trading firms to downplay, or artificially attempt to reduce those risks in order to attract new customers and keep them coming back.
It’s not just the SEC that’s concerned either. The NASD has recently taken action to curb day-trading abuses and even the U.S. Senate has gotten into the act (after all, it is an election year).
The SEC has already moved forward with plans to scrutinize objectionable practices. The Commission, which reviewed selected day-trading firms in 1999, plans to inspect every day-trading operation before the end of this year. While the initial sweep did not uncover widespread fraud, the Commission did find persistent violations at some day-trading firms.
Margin For Error
Last month, the SEC struck its first blow against these alleged violators, filing actions against two firms - All-Tech Direct, Inc. and Investment Street Company, and nine individuals associated with those broker-dealers. Both firms offer customers the use of trading facilities that are fully equipped with computers and specialized software for rapid order entry. The Commission has charged that the firms, and people associated with them, violated federal margin lending provisions by providing loans to day-trading customers in excess of legal limits.The use of margin can be a slippery slope, particularly for inexperienced or undercapitalized investors. Margin rules permit customers to borrow funds from brokerage firms in order to purchase securities - but there are strict limits on the amounts of those loans. Generally, a customer may not borrow more than 50% of the cost of the security. He or she must put up the other 50% in cash. Once the securities are purchased the customer’s equity interest in them is the value of the securities minus the amount of that margin loan. If the customer’s equity in the securities falls below the level designated by the brokerage firm (usually 30% to 40% of the value of the stock), a margin call is triggered and the customer must either sell stock or deposit more funds.
Day-traders routinely rely on margin loans to purchase securities at prices, and in volumes, that exceed their available cash. Still, like every other customer, they must comply with margin rules and use their own funds for at least one half of the purchase price.
According to the SEC, All-Tech Direct, Inc. and Investment Street Company attempted to circumvent these margin rules. The Commission alleges that these firms were able to generate greater commissions for themselves by making it possible for customers to continue day-trading, even though they lacked sufficient funds to do so.
In the All Tech case, the Commission alleges that, throughout 1998, the firm and seven individuals were responsible for making 103 unsecured loans to customers so that those customers could meet margin calls totaling $3.6 million. The loans enabled the customers to continue trading (and therefore paying commissions), even after the balances in their accounts fell below required levels. All-Tech and the seven associated persons are contesting the SEC charges.
The allegations against Investment Street were similar. Principals of the firm were charged with responsibility for making at least twenty-two unsecured loans to help customers meet margin calls of at least $250,000. In addition, the SEC claimed that Investment Street allowed unregistered individuals to conduct business that required NASD registration. Investment Street, two associated persons and Dynamic Trading of Miami, Inc. (which provides administrative services for Investment Street) have settled the charges without admitting or denying the allegations.
Risky Business
Day trading is risky enough when everybody involved -- the brokerage firms and their day-trading customers -- play by the rules. When they don’t, the risks are magnified.Do customers understand the risks of day-trading; the possibility they could lose all of their money? Members of a U.S. Senate subcommittee investigating day-trading practices fear that investors may not be getting a balanced picture. In recent hearings on this subject, a Senate panel expressed concern that some brokerage firms aggressively promote the potential upside of day-trading while minimizing those risks. The subcommittee’s conclusions were not encouraging for the amateur day-trader.
What did they find? Apparently many of their worst fears were confirmed. The panel discovered that some brokerage firms have been piling up huge profits at the expense of investors who are not trained or prepared to handle the high-risk, rapid fire strategies that are the hallmark of day-trading.
In fact, for amateur investors, day-trading is "little more than a game of chance," according to the subcommittee chairperson, Maine Senator Susan Collins, who pointed out that many of these investors are undercapitalized and poorly trained. According to Senator Collins, they have virtually no chance of success - over 75% of all day-traders lose money.
It may be cold comfort to those investors who are losing money, but day-trading firms are flourishing. Fifteen firms investigated by the Senate subcommittee reported a total of over $541 million in gross revenues in 1999, with profits of about $144 million -- a 276% increase in revenues since 1997.
Which leads to one significant question. Are those profits growing because the firms have been ignoring rules and regulations? The Senate panel expressed concerns that some of those broker-dealers may be using improper, abusive and deceptive practices to boost their business. They also found (as had the SEC) that some day-trading firms encourage customers to trade beyond their means by arranging loans for customers, often at high interest rates.
As Senator Collins declared, "[i]f day trading firms fail to disclose the risks and entice unsophisticated investors with misleading ads or exaggerated claims of profitability, regulators and the industry must put a stop to it."
A good first step? According to Senator Collins, "consumers who choose to day-trade must be warned that they could easily lose their entire investment." She might also have pointed out that, if those consumers are trading on margin, they could also wind up losing their stock holdings or owing money to the brokerage firm processing their trades.
Alarmingly, the panel also discovered that some firms allow customers to day-trade even if those customers don’t meet suitability standards. In some instances, they discovered that firms had even altered customers account documents to make it appear that the customers had sufficient income, net worth and experience to engage in day-trading.
How do day-trading firms feel about the subcommittee’s inquiry? No surprise - representatives of that industry feel they have been unfairly targeted. One vocal opponent of these findings is Harvey Houtkin, CEO of All-Tech Direct - one of the two firms recently charged with margin abuses by the SEC. In testimony before the Senate subcommittee, Houtkin claimed that the congressional inquiry was "a search and destroy mission, a crucifixion, an ambush."
Fortunately for investors, regulators do not agree with Houtkin. As we see in our next installment on day-trading, the NASD has joined with the SEC to crack down on day-trading violators.
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