Summary: Day Trading Need To Know
I truly believe that, when it comes to investing, knowing a little bit is much more dangerous than knowing nothing. When I first started learning about trading, I thought that I could learn everything I needed to know to make profitable trades in a matter of weeks. I didn’t realize the extent of my own ignorance, as I somehow believed that every piece of information I consumed was available only to me and I could simply outsmart all other market participants. It is only as my industry exposure increased and I began studying the markets more (both as a hobby and through the CFA curriculum) that I realized how much there is to know about investing. For anyone who is eager to put their stock picking skills to the test and start day trading, here are some risks you should keep in mind:
1. Consider the strength of your day trading competition.
Would you blindly agree to enter a boxing ring if you didn’t know who you’d be fighting? There is someone on the other side of every trade that you make. Who is this other person? Are they someone like you, sitting in their basement office and relying on CNBC interviews and SEDAR reports? Or perhaps it’s a Wall Street hedge fund taking the other side of your bet and they’re using a team of well-paid analysts and quantum computing infrastructure to profit off of mispricing that exists for a fraction of a second.
Just like with other endeavors, you must give credence to the strength of your competition when making the decision to day trade. At its most basic level, you are in competition with the party on the other side of the trade, as they believe that the stock will move in a different direction than what you believe. Given the faceless nature of trading, it is easy to underestimate your opponent in the transaction. Do not brazenly believe that your side of the trade is always the smart money.
2. Short-term trades may have different tax implications.
Some recent shifts in the investing industry have made the idea of more frequent portfolio turnover more appealing. An example of this is that many brokerages are moving to commission-free trading. However, punitive as they may be collectively, your decision to buy or sell shouldn’t be too heavily influenced by a $9.99 trading commission. Rather, more emphasis should be placed on the tax implications of day trading. The revenue generated from day trading may be considered as business income in Canada. This means that 100% of your capital gains will be taxed as income and subject to your current tax rate, rather than deducting 50% of capital gains if you are an ordinary investor (your losses are also 100% tax deductible, but this concession likely won’t be too comforting. You don’t want your day trading to be a loss-generating endeavor).
Even if you are day trading in a registered account (such as an RRSP or TFSA), the funds generated will may still be treated as business income. Registered accounts were not designed to encourage day trading, but rather smart, long-term investing. The benefits of tax-free growth can be destroyed by day trading.
3. You will be tempted to act on incomplete information.
In some ways, investing is a lot like fishing in that the key to success is patience. Once the hook is in the water, your primary responsibility is to do nothing but enjoy the sounds of nature. Likewise, you should spend the majority of your time doing nothing with your investable funds. Establish the proper asset allocation, invest your funds accordingly, and then rebalance based on pre-established rules and/or timelines.
Day trading flies in the face of this virtuous patience. With day trading, you are sitting at your desk, staring at your wall of monitors. Your Bloomberg terminal is steadily quoting prices from all major exchanges and every position you follow. With all this stimulation, you feel compelled to take action. This temptation to do something, no matter how ill-conceived, can be the path to financial ruin.
4. You will enter and exit positions based on emotion.
Many people are subject to the bias known as loss aversion, whereby a loss of funds feels roughly twice as bad as an equivalent gain feels good. Loss aversion can be particularly destructive when it comes to investing. It often leads people to sell their winners too early and let their losers run for too long with the hope that they will come back. It reasonably follows that spending increased time staring at your positions will make you more likely to act in conjunction with this bias.
You may think that you won’t fall into the same traps that other day traders do, that you are immune to the biases that plague your competitors. Just remember, they all feel the same way about themselves. Not everyone can be right.
There is one advantage I would highlight when it comes to frequent trading: sometimes the best way to learn is by losing money. It is extremely humbling to spend hours researching positions and put your hard-earned money to work just to see it evaporate. It is the pain of losses that spurred me to learn as much as I could about investing and personal finance. With that said, just make sure that you aren’t day trading with anything that you can’t afford to lose.
Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.