Day trading, the whipping boy of many market makers, has returned after the massive problems of a three-year bear market.
"It is today an understated, but very important part of liquidity and agency capital," said William O'Brien, chief operating officer of Sungard's Brut ECN. "It is a very vital source of liquidity."
The bull market has lifted all kinds of volume and that includes day trading, added Cromwell Coulson, chief executive of the Pink Sheets.
But that doesn't mean that doctors, lawyers and other successful professionals are now chucking their careers again to stare at computer screens 12 hours a day. That's according to Schonfeld Group officials, who say that active day trading, both on the proprietary and retail side, is making a comeback.
The return of the bull market has resurrected the positive economics of day trading. But it has also resurrected the controversies over whether day trading is a service or a "phantom kind of trading" designed to generate superfluous revenues through rebates and access fees.
Critics and foes agree on the following: For a short period in the late 1990s day trading was perceived by many as a kind of easy money business in which almost anyone with a computer could make a nice living.
At its height, day trading advocates, such as Harvey Houtkin of the now closed All-Tech Securities, several years ago disastrously predicted that day trading would overtake Nasdaq and the NYSE. They were very wrong.
Schonfeld cites the return of a bull market but says the scars from the recent bear period have not healed for many investors. That has meant that the "amateurs" are no longer in the business.
"The people who expected to make a quick buck in day trading have come and gone," according to Steven Schonfeld, chairman of the Jericho, New York-based firm, which has about a dozen offices around the country. "That has left those who are serious minded about trading," added Schonfeld, who refers to day trading more elegantly as active trading.
Proprietary and Retail
Schonfeld is now trading close to 140 million to 150 million shares daily, according to a spokesman. Some 30 million shares of that flow comes from clients trading for their own accounts. The rest is from proprietary trading. The firm has about 1,200 traders. Some 700 trade on the proprietary side. The rest risk their own money as customers. Growth has come from both the proprietary and retail businesses, Schonfeld said.
Proprietary traders receive a piece of the profits, while customer payouts are determined by a monthly schedule based on volume. Rock bottom prices are $3 a trade for the most active traders.
The average trader at Schonfeld is in his or her 30s or 40s and he or she is changing. In the glory days of the late 1990s, day traders were "knocking down our doors," said Schonfeld. Now it is necessary to do some advertising to find talent.
Schonfeld, which bet big on retail trading at a time when many firms were retreating to institutional business, is one of the few survivors of the massacre of the day trading firms in the last bear market. The brutish bear swallowed firms such as Heartland and Broadway, which Schonfeld took over. Schonfeld is also hoping that its mathematical approach to day trading will be more successful than individualistic strategies used by some other firms.
Despite Schonfeld's selectivity, the volume of day trading in the industry overall has been on the rise recently. "Day trading customers are starting to return, not in the volume that it was in the late 1990s, but they are starting to come back," Schonfeld said.
Recently much more money has been ending up in what some traders regard as the Las Vegas of the OTC industry. Bulletin Board volume was only running about 700 million shares daily a year ago. However, by September, the number had jumped to almost five billion shares daily.
Bulletin Board trading is somewhat different in style than conventional Nasdaq trading. It has a different structure though many of the stocks are now trading in the Bulletin Board. That's because they were delisted from Nasdaq.
At Schonfeld, retail traders are usually using Level II screens as do some proprietary clients. Most Schonfeld group traders use Level I screens.
Total trading at the firm is equally split between listed and OTC business. However, most retail clients are concentrating their trading on Nasdaq while proprietary traders are not permitted to trade Bulletin Board stocks, according to a spokesman. He also noted that Bulletin Board spreads are wider than Nasdaq spreads.
Bulletin Board volume often is recorded in some of the most risky net stocks. These were high-flying stocks that skyrocketed in the 1990s and were then part and parcel of the bubble that blew up in the bear market of 2000-2002.
Matthew Nestor, chief of the Massachusetts Securities Division, believes that day trading has risen from the ashes. But those ashes could lead to fires in the trading industry. Day trading – especially in the wake of the market meltdown that wrecked many firms and led to a number of regulatory sanctions – is a kind of trading that is dismissed by many Nasdaq dealers as little more than another form of gambling.
The access fees and liquidity rebates triggered by day trading firms, the same as many of those generated by ECNs, have been the source of countless debates. For example, the Security Traders Association has argued that access fees should be abolished because they lead to "a convoluted rate structure." The fees were blamed by the STA for locked and crossed markets.
The White Paper
In a White Paper, the STA cites an example of a customer interested in selling a stock that was currently quoted at 10.00-10.05. "Traditionally the customer would execute its orders by executing a 10 bid," the STA noted. "In today's rebate scheme, the broker would be better off entering a sell order in an ECN at 10, instead of hitting the existing bid, and creating a locked market, thereby receiving a rebate and, in the process, possibly depriving the customer of an execution."
Schonfeld concedes that dealers have been critical, but he rejected this example. "It's hard to define what an access fees is. We're making money by providing liquidity, not through fees," he said. Schonfeld adds that day trading firms are merely providing a needed alternate form of liquidity for a stock market that has grown by leaps and bounds as the individual investor has returned.
Cleaning Up
Competition from the day trading firm, Schonfeld argues, has lessened "the rip-off effect" of specialists and market makers. But one man's good business is another man's regulatory nightmare, according to one day trading firm critic.
"There are good and bad day trading firms out there. But the individual really needs to be dealing with firms that are licensed to be in the business and have the standing of being a large firm with a good track record," said Frank Childress, manager of principle trading for A.G. Edwards.
Childress says that, during the heyday of the 1990s, many day traders were trading for other investors even though they were not licensed to do so. Still, Schonfeld contends that day trading came about because the service was needed.
"If you take the specialists on the New York Stock Exchange and the market makers on the over-the-counter, they provide a service. But, now that the market is trading billions of shares, these people can no longer handle it," Schonfeld said.
Still, Childress questioned the quality of the service day trading firms are offering.
"Many day trading firms are little more than order-entry agencies," Childress said. But day traders, Schonfeld counters, are providing another level of liquidity that is available both in bear and bull markets. They are also cutting into the market maker's profits.
"When Joe Public wants to sell shares in a bear market and the specialists or marker makers don't want to buy from him, we're buying from him at many different levels and creating a stable market," Schonfeld said.
So dealers are upset, he adds, because day trading firms are "creating an edge, preventing many stocks from going into a free fall."
To which Childress responds: "They're not putting up capital. We are." He also says that much of the business would dry up if the regulators agreed with the STA's suggestion and eliminated access fees.
Childress says that the bad day trading firms are often little more than collections of individual traders, many times not properly supervised.
Indeed, another criticism of Schonfeld is that his firm isn't interested in people who have never traded before. "We're very selective. We don't want to waste someone's time. We'll take maybe one out of 20 candidates. We really look for someone who has a little confidence, who will stick it out during bad times and has a bit of gambler's blood," Schonfeld said
Nevertheless, Schonfeld rejects the stereotype of day trading critics – that day traders live off of ECN access fees and pennying strategies.
"It's not a game of pennying anymore. A lot of our traders aren't holding [positions] for minutes. They're holding on for hours or a day or two," he said. Holding on for long periods results in typical gains of a point or two, he notes. Schonfeld concedes that he also has some traders who make money by routing trades through ECNs and are paid for obtaining liquidity.
Schonfeld and Childress agree on one point: Both are unsure if there is now going to be a repeat of the 1990s boom in day trading. Schonfeld says there is a canard about day trading firms: It is that one only needs traders and capital.
Firms fail, Schonfeld adds, because they don't know how to develop the trading talent and don't have models that can survive when the fat times become a memory.
"You have to know how to train traders, risk manage them, allocate capital, provide them with a trading strategy, give them a quant group, and have special software that is better than others in predicting short-term indicators," according to Schonfeld.
A Strong Ego
Day trading, says Schonfeld, requires confidence and a strong ego. Besides that, the successful day trader is going to change over the next few years. Day trading is going to require someone who is less emotional, more disciplined and maybe a bit nerdy.
"In the past, there was a lot of seat of the pants people who became good traders," Schonfeld said. "But now we are going to be looking for more mathematically oriented and more computer literate people because we're all going to have to compete with the black boxes and the computer-originated trading."
