I began my professional career as a “day trader” a little over thirteen years ago. Little did I know at the time that I would one day become a strong advocate for banning myself from the market.
The Institutional Day Trader
First, let me offer a little bit of background information regarding “day trading” before I explain why it, other than high frequency trading (HFT), has truly become the scourge of the US equity markets.
Since the nineteenth century individuals have engaged in day trading. Initially, it was done by a small group of people, whom I like to refer to as “insiders” who worked for the specialist firms whose job was to maintain a “fair and orderly” market in each stock listed on the NYSE. These specialists had a station on the floor of the Exchange where all of the buying and selling would take place for each stock that was listed. Occasionally, a specialist would purchase a position for their own account with very little risk as they had access to all of the buy and sell orders for each security.
In the latter part of the twentieth century the NASDAQ market was created as an alternative to the NYSE. This was a dealer based market with each “market making” firm required to maintain a bid/ask quote for each stock they wanted to act as dealer. Occasionally these firms would “day trade” as well. But quite frankly, based on talking to my friends who were NASDAQ market makers, it is my understanding that they rarely would have a position “at risk” and were mainly taking orders for large institutional clients.
The third group of insiders who traditionally were opening intraday positions for some quick short term gains were those on the trading desks at the large investment banks. Traders at Goldman (still exists–thanks Paulson), Lehman (bit the dust), Merrill (somehow survived—thanks Bernanke), Morgan (still exists–thanks Seoul, S.K.), Bear (Ripper!), and Smith Barney (thanks everybody) would use their access to large institutional order flow to gauge whether it was prudent to take a position in a given security. My understanding through various conversations, including a youngster I interviewed the other day who did a brief stint at JPM, was that these institutions don’t know their a***s from their elbows with respect to how to properly formulate a short term trading strategy (except GS who just bets against all of the other major players). I also learned that JPM had no system in place to ascertain their risk with respect to trades they were putting on in their own account. No wonder Dimon shut down JPM’s prop trading division and has refocused efforts on making the no-risk spread on loans that have been made available to them via the Fed’s current interest rate policy.
So the above groups, collectively the “Wall Street Insiders” had direct access to the markets and a ton of information which allowed them to make billions in short terms profits for a period of many years. You may have even read about the billions extra in profits that were earned by the major NASDAQ institutions back in the 1990’s by illegally fixing the bid/ask spread in all NASDAQ stocks. I certainly remember that stuff as I was trading a personal account at the time and received over $10,000 as part of the class action settlement with Merrill, Goldman, Morgan, Smith Barney, and Bear Stearns. That money was well spent on a down payment for my first plasma TV.
Emergence of the Non Institutional (Evil) Day Trader
Something funny happened with the introduction of the NASDAQ market and the stock market crash of 1987. The markets became more user friendly to individual traders/investors who previously had been frozen out by the major markets. Basically, in October 1987 when the markets began their worst free fall ever, the NASDAQ market makers accidentally and simultaneously all tripped over their phone lines and every individual investor who was trying to get out of their positions received a busy signal.
Someone at the SEC was suspicious as to how all of the phone lines could have been simultaneously tied up at every major market making firm and decided that a system needed to be put in place so individuals could electronically enter orders and get out of positions without direct human contact with a NASDAQ market making firm. That was the birth of the Small Order Execution System (SOES). This system gave direct electronic access to the NASDAQ quote montage and allowed individual investors to receive automatic executions of up to 1,000 shares in any NASDAQ security.
In the mid 1990s several firms emerged that were able to take advantage of the SOES system and make large profits via short term momentum trading. The major players who had been fixing the spreads for many years in NASDAQ stocks saw their profits reduced since they were now actually required to honor their bid/ask quotes. So, they began the process of lobbying the SEC to dismantle the SOES system. The Insiders figured that by eliminating SOES, the direct access professional trader that had emerged would disappear and things would go back to business as usual. But that wasn’t the case.
Arthur Levitt, the SEC Chairman at the time, was interested in making further changes to open the markets to a larger base of traders and investors. Levitt spearheaded changes such as decimalization and ECN access to all of the major US equity markets. Spreads narrowed and liquidity increased, making it far less expensive to actively trade US equities. But it was pretty much all down hill from there. By narrowing spreads and reducing trading costs this opened the floodgates for thousands of individuals who were interested in becoming professional intraday traders. These people would have the gall to open small positions during the day (less than 10,000 shares) and liquidate these positions before the markets closed each day. Just Awful!! What value were they possibly adding to the markets? Guys like Joe S, who you may have seen on one of his several dozen TV appearances recently, not only despises HFTs who make his job more difficult, he does not want individuals to make intraday trades either. I think he said it best when he referred to our firm as a bunch of “leeches”.
Think about it. The market was becoming saturated with a lot of very small and annoying players. The large trading institutions who previously were bilking the large investing institutions for billions of dollars each year now had to compete for stock with little players such as myself. There were a lot of angry institutional traders who thought with the elimination of SOES that they no longer would have to deal with savvy short term traders eating into their monopolistic profits. If the SEC would simply ban short term trading by individuals such as myself it would be easier for the Joe Ss of the world to execute their large buy and sell orders and collect commissions from their clients. Who am I to stand in the way of the continued profitability of these institutional brokers? They are an essential part of the US equity markets today. 🙂