Do it yourself: Day Traders

Wednesday, May 29, 2024

A visit to the street

Ravi Bhatt, a brilliant student, completed his senior school education in 2018; went to a prestigious college in the US; completed his post-graduation in 2023. Worked some odd jobs in the interim and also interned with a top consulting firm. After finishing college, Ravi searched for a suitable job, but could not find any for more than six months. Finally, he returned to India in the autumn of 2023 and unsuccessfully tried for a decent job in India for a few months. Earlier this year he borrowed five million rupees from his father, a successful surgeon, and started trading in stocks and derivatives. Being a brilliant student, good in mathematics and data analytics, he soon developed a trading model of his own. He is now a full-time stock trader; making decent money; perhaps more than what he could have earned, working long hours for a consulting firm.

Mitesh Gupta, an average student, passed senior school in 2021. He failed to pass the admission test for graduate school. He joined a distance learning course in 2022 but did not like it. His father retired from a mid-level government job in early 2023. He convinced his father to give him Rs two million from his retirement corpus and started trading stocks and derivatives. He learned a few things from YouTube videos, blogs, and social media posts. He has lost more than half of his initial capital in the past year but is hopeful to recover all lost money and make a decent living out of this occupation.

Arvind Agarwal runs a small packaging material manufacturing unit. His business had not been growing for the past few years, especially after the implementation of GST. He advised his 29-year-old son Anuj, a commerce graduate, to learn and start trading stocks as a side business. Anuj is learning stock trading from his friends, social media, and blog posts. He has also taken some online classes for technical analysis, and option strategies, etc. Anuj now remains glued to his laptop from 9 AM to 3:30 PM. In the past three years, he has been able to earn 18% CAGR on the capital employed in stock trading.

Neha Arora, a software developer, works as a mid-level manager with a top IT Services company in India. Her salary has grown at a CAGR of 8% over the past five years, much less than her household expenses. She started trading stocks during the Covid-19 lock-down while working from home. So far, she has been able to supplement her salary with the trading income. Neha plans to increase the capital deployed for trading and make it her full-time profession in the next three to four years.

Evidently, in the past four years, stock and derivative trading has become a full-time profession of choice for a variety of individuals. Incidentally, it is not an India-specific phenomenon. Similar trends are being reported from countries (developed and developing) across the world.

We have already reached a situation where a handful of people are innovating, creating businesses, and building wealth; whereas an exponentially higher number of people are just piling on their success, and trading their ideas, success, failures, business cycles, and performance with little or no sense of commitment to their business. Cynically speaking, a part of society is becoming like the plot of the much-acclaimed 2019 South Korean movie ‘Parasite’.

The question is “Is stock trading as a full-time profession" sustainable if a much larger number of individuals make it their profession of choice?”

I shall try to find an answer to this inquisition over the next few months. There are strong arguments on both sides. For example, —

· Many traders quote the traditional market saying, “Owners of businesses make more money than the managers of the business”. This implies that passive shareholders of a company shall earn more than the people who are managing the business. The problem in this argument however is that not many traders are interested in becoming owners of businesses. They are happy buying and selling stocks for immediate 3-5% gains.

· There is an argument that stock trading is a perennial business. It continues even during wars, natural calamities, and pandemics. There is no business like this. This argument comes mostly from young traders in their 20s and early 30s. They have not seen a three-decade stagnation in the Japanese market; over a decade of stagnation in the US and the UK markets, and frequent disruptions and stagnation in the Indian markets during the 1990s.

· The strongest argument in favor of stock trading is that in this profession anyone can get significant leverage easily. Thus, the opportunity to multiply the capital is the best in this activity. The easy leverage part is true. But it works as a double-edged sword. The probability of losing the entire capital rather swiftly is also the highest in this profession.

· The ability to earn above normal return depends on a combination of capital base, risk appetite, and skill set of the trader. This could be different for all traders. Traders with a small capital base, poor risk appetite and/or inadequate skill set are most likely to underperform the others, just like any other business or profession.

· The sustainability of stock trading as a regular profession would depend on a continuous supply of quality businesses that employ new ideas (product, process, or service) and innovative techniques. If new quality businesses are not continuously added to the existing inventory of stocks available for trading, a serious demand-supply mismatch may occur in the market – driving the stock prices into the realm of irrational and exorbitant. That would make the entire stock market prone to sudden crashes, imperiling the overall economic growth of the country. So, to sustain so many new traders in the stock markets, we would need a matching number of entrepreneurs successfully seeding & cultivating new ideas, and providing adequate inventory for traders to pursue their activities.

· If stock trading becomes a medium of livelihood for millions of youth, the entire regulatory framework may need to be overhauled. A massive paradigm shift may be needed to redefine the way stock trading is presently perceived by policymakers, regulators, and society in general. For example, RBI considers it an undesirable activity and imposes a plethora of restrictions for credit to stock traders. This activity is taxed heavily, instead of getting the usual “job-oriented” activity incentives. SEBI and Finance ministers have openly spoken against the popularity of option trading as a regular activity. The regulations do not provide any protection to regular traders.

Tuesday, September 8, 2020

Compounding for Robinhoods

One of the most popular concept of invetsing is the "power of compounding". Almost every prominent investor and financial author has emphasized on this concept.

The principal of compounding, insofar as financial investments are concerned, works on the basis of three key factors (a) regular investment; (b) staying invested for long period; and (c) rate of compunding. To take full advantage of the power of compounding, it is therefore essential to:

(i) Invest regularly;

(ii) Reinvest the return on investment; and

(iii) Try investing at the maximum possible rate of return, without of course compromising the safety requirements.

Does this imply that the concept of compunding is relevant only for investors who could "buy and hold" an investment for sufficiently long period of time?

This question is more pertinent to answer is whether the concept of compounding is relevant for stock traders also; especially when currently the markets are being dominated by the "Robinhoods" - the individuals indulging in short term (mostly daily) trading in stocks.

I beleive that compunding does work for the day traders and short term traders also. In fact it works more hard for them as it impacts them on both the sides, i.e., in gains and in losses. For example, consider the following:

(a) If you buy a tocks Rs100 on Monday and it rises 10% on Tuesday, the gain is rs10 and the closing value would be Rs110. If the stock rises 10% again on Wednesday, the gain would be Rs11 (10% of Rs110) not Rs10. And so on.

(b) If a trader buys a stock on Monday at Rs100, and it rises by 10% on Tuesday, the gain is Rs10. However, if it falls 10% on Wednesday, the loss will be Rs11 and not Rs10.

(c) If a traders buys a stock at Rs100 and it falls by 25%, the value of the stocks wouild be Rs75. It would now need 33% gain in stock price for the trader to recover his cost. If the fall is 50%, the gain required to break even would be 100%.

If you find it too simple and nothing much to bother about, add the transaction cost to these examples. In case of traders, the transaction cost of aposition compunds witrh every trade. This is the most ruthless element of the entire trading process. It does not care if the trader is making or losing money. It just keeps gnawing on the capital of the trader with each trade he executes. To under stand the magnitude of this consider this example.

A trader pays 0.2% for a delivery settled trade. The total transaction cost, including l;evies and other charges would come to appx 0.4% in his case. If he rotates his position five time in a month, assuming there is no net change in the price of stock he would have paid 4% as transaction cost only, i.e., massive 48% per annum. If he repaets this feat for one full year, he woould have lost 48% of capital in transcation cost only.

The case would be worst, if he is trading by using margin financing. The cost of margin financing (ranges efectively between 12% -30%) also keeps compounding each day. In many cases the etire capital of traders gets eroded just by transaction cost and margin interest.

It does not stop here. There is another devil eyeing the capital of the trader. If the trader sticks to a losing position for over one yyear and then switches to another "rocket", which would give enough return to make for the losses of the dud, the finance minister may not spare you. The losses of "dud" in this case would be long term and gains of "Rocket" would be short term. The trader will end up paying 15% tax on these gains!