Rising Trader Ranks Challenge Old Order

In every great bull run on Wall Street, someone or something comes to symbolize what’s wrong with the market--”wrong” usually meaning excessive profits earned at others’ expense.

From the “go-go” mutual fund managers of the late 1960s to penny-oil-stock investors in the late 1970s to takeover-stock traders in the mid-1980s--Hollywood’s Gordon Gekko--the villains have uniformly been accused of unbridled greed. We cheered when they finally crashed and burned.

Today, the personification of late-1990s bull market greed is the “day trader,” a catchall term for an army of individuals trading stocks online with investment time horizons sometimes measured in seconds.

Using technology formerly reserved for Wall Street pros, day traders are accused of driving market volatility to extremes (think Internet stocks), overloading computerized trading systems, borrowing excessively to speculate, and misrepresenting themselves to each other and to the ranks of investors who are mulling whether to jump into the game.

The day-trading phenomenon has in recent weeks been the subject of pointed comments by no less than National Assn. of Securities Dealers Chairman Frank Zarb, Securities and Exchange Commission Chairman Arthur Levitt and, on Feb. 11, four key members of Congress, who asked the General Accounting Office to conduct a probe of the industry.

But what exactly is the day-trading “crisis”--and who does it really hurt?

At a minimum, the concerns triggered by the rise of the small trader are rife with contradictions:

* Far from some unified force, day traders, as popularly defined, fall into two separate camps.

The “professional” day trader--the hyperactive, full-time trader singled out for most of the scorn--may number between just 3,500 and 4,000 nationwide, operating from about 20 brokerages that have sprung up specifically to cater to them, according to the Electronic Traders Assn., a day-trading industry group.

The rest of the people routinely lumped into the day-trading army are the 7.5 million Americans who now have online brokerage accounts at such well-known firms as Charles Schwab and E-Trade, up from 1.5 million in 1996. Yet, an online investor isn’t necessarily a day trader--something that is increasingly lost in the hubbub.

* While the universal criticism is that professional and amateur traders now are greedily chasing a fast buck by feverishly buying and selling stocks, it isn’t outrageous profits that seem to concern regulators most. Just the opposite: They fear that most of these traders are losing tremendous sums.

“They’re not putting the system at risk,” said Dan Mathisson, head stock trader at D.E. Shaw Securities, a New York-based institutional trading firm. “They’re putting themselves at risk.”

Indeed, by some estimates no more than one or two of every 10 professional day traders make money. And only a fraction of those reel in enormous profits. But by the time most people realize they don’t have the right stuff, they’ve often chewed through a sizable chunk of their savings.

“In our experience, many, many more people lose money than make money in day trading,” said Denise Voigt Crawford, Texas’ securities commissioner. “We have seen individuals who have been wiped out, who have lost their entire life savings.”

* Amid accusations of widespread abuses at professional day-trading firms--including allegations that some firms encourage traders to cover others’ debts on a daily basis to paper over huge losses--some regulators now seem to want the firms to exhaustively screen potential traders and weed out those with insufficient capital and investment knowledge.

“Investors must be properly warned about the risks they may be taking in this environment with unprecedented levels of day trading,” the NASD’s Zarb warned in a Feb. 4 letter to member brokerages.

But the day-trading firms counter that government watchdogs are saddling them with rules not required of mainstream firms such as Merrill Lynch or Charles Schwab.

* On a philosophical level, even critics of the surge in trading by small investors concede that such activity is only likely to increase.

“The genie is out of the bottle and it ain’t going back in,” said E.E. “Buzzy” Geduld, president of Herzog Heine Geduld Inc., a veteran Nasdaq brokerage. “I think that people have learned that this is sort of a game, and you can make money playing the game.”

Though any individual investor who buys and sells a stock in one day is technically a day trader, the term refers primarily to people using special trading terminals provided by niche brokerages. That distinguishes day traders from the burgeoning corps of online investors who research stocks and place orders over the Internet for as little as $5 a trade.

While online investors generally trade as a hobby around their regular jobs, day traders often bet huge stakes and try to support themselves full time by trading.

Made possible by dramatic advancements in technology and changes in Nasdaq rules in recent years, the day-trading craze went mainstream after a January 1997 article in Inc. magazine told of how firms like Block Trading had finally given individuals a way to go toe-to-toe with professional Wall Street traders.

“The Internet, a couple of media stories and several of the newer [brokerages] have made it seem like this is the new McDonald’s. It’s the new way for everyman to make money,” said Phil Feigin, executive director of North American Securities Administrators Assn., which represents state securities regulators.

Yet it’s people like David Anvar who the regulators believe have become the norm in the ranks of full-time day traders.

$26,000 of the $60,000 He Borrowed Is Gone

When Anvar started day-trading stocks a year ago, he badly needed his luck to change.

Once a millionaire real estate developer, the 59-year-old Huntington Beach resident had lost his company to bankruptcy in 1995 and later nearly died from a flesh-eating disease.

With his wife forced to work for the first time in her life, as a saleswoman at Macy’s, Anvar needed money. And after seeing an ad for day trading, he thought he had a way to make some in a hurry.

After investing successfully for years through a stockbroker, Anvar took what he thought was the logical next step: He borrowed money from a family member, took a day-trading class and set out to make big money. He hasn’t.

In fact, like many other day traders, Anvar has lost money, at this point about $26,000 of the $60,000 he borrowed.

“You come in and you think it’s easy,” Anvar said. “But after you lose all your money, you figure out it wasn’t easy.”

At his lowest point, he was down about $42,000 more than two months ago. Anvar says his partial recovery has come not from day trading, but largely from holding stocks for several days or weeks at a time.

Regulators, collecting far worse horror stories from some day traders over the last few months, have begun to zero in on some of the specialized brokerages that have led the day-trading boom. Many of the firms advertise aggressively to attract investors, then charge fees of $5,000 or more to teach what investors assume are the secrets of profitable trading.

Some firms seem to all but guarantee profits. A newspaper ad for one reads, “How would you like to $Get Rich$ Day Trading?” An ad for a how-to book asks, “Are you ready to quit your day job?”

The payoff for the brokerages goes well beyond the class fees: They also charge commissions on every trade investors execute over their systems. As with all brokerages, that gives the firms incentive to encourage trading. And some portion of day-trading shops, regulators say, keep their customers trading well into ruinous losses.

“The people who are running the schools and renting the machines and teaching you how to do it get paid whether you win or lose,” said the NASAA’s Feigin. “They’re in it to get you to play the game. So whose interest do they have at heart?”

Meanwhile, the firms themselves incur little risk: Investors who fail usually have signed agreements in advance that force them to arbitrate disputes rather than sue in court for damages. And as the losers drop away, they leave no trace for the new crop of would-be traders who follow them.

In the most notable regulatory action to date, Massachusetts filed a complaint against the Boston branch of now-defunct Block Trading. Among the charges: 67 of the office’s 68 traders were losing money. Block has denied the charges.

“The overall impression they [day-trading brokerages] give to people is you can make a lot of money doing this. Well, where are the success stories? Where are they?” said Matthew Nestor, Massachusetts’ securities enforcement chief.

“And when you ask them for it,” he said, “[they say,] ‘Well, we don’t keep records that way.’ OK, well how can you make the claim if you don’t keep records that way?”

Day-trading firms counter that they fully disclose the risks and do everything possible to help people succeed. Tales of investor losses are wildly overblown, they say, adding that many traders make money.

Jim Lee, president of Houston-based Momentum Securities Management, which runs 10 day-trading offices, acknowledges that most beginners lose substantial sums. But investors who preserve their capital at the outset can do well eventually, said Lee, who also heads the Electronic Traders Assn.

“I don’t care what office you’re in, at what firm or what system, it’s going to take you four to six months to get over that learning curve,” Lee said. “The learning curve can be very painful. It can be $10-, $40- or $50,000 to the downside.

“But if you have that expectation going in and it’s properly disclosed to you, and you expect it and you work your way through it, when you emerge out of it the potential is very real and there’s some real success there,” Lee said.

Late last month, Momentum released one of the first known attempts to measure day-trading performance. The three-month survey late last year of 107 traders in Momentum’s six Texas offices showed that 58% of newcomers lost an average of $21,479.

However, almost two-thirds of traders who got past a three-to-five-month “learning curve” averaged gains of $28,426, according to the study.

The study did not disclose how many traders made it through the initial three-month period--the key question, critics say.

Regulators blast the study’s methodology and contend that failure rates are much higher. In Texas, for example, investigations show at least 80% of day traders lose money, Crawford said.

To counter criticism of their high-cost classes, day-trading shops say newcomers will fail without them, and claim the courses actually aren’t profitable because of overhead and tuition rebates.

There’s “an enormous disincentive to run a revolving door,” said Lee, adding that for every 33 investor “inquiries” in Texas, only one person becomes a customer.

And why, day-trading brokerages ask, should they have to prove that a majority of their clients make money, when Merrill Lynch and other old-line brokerages face no such requirement?

Concern Is Over Market Volatility

For mainstream Wall Street, whether a few thousand day traders make or lose money matters little. The concern for the market overall is the surge in volatility that day traders--and less active but vastly more numerous online investors--have helped fuel, particularly in Nasdaq stocks.

Day traders already make up a whopping 12% to 15% of average trading volume on Nasdaq, a figure the Electronic Traders Assn. says is rising.

Add in the millions of online investors, which the ETA says account for another 20% of Nasdaq volume and often mimic day-trading strategies, and trigger-happy small investors may now control one-third of Nasdaq activity.

The extraordinary price swings in many Internet-related stocks since last summer have been tied directly to the activities of day traders and to online investors trading from their homes and offices. The stocks’ whiplash-like moves have increased the odds that people can rapidly make--or lose--large sums.

Day traders have wreaked “havoc on the marketplace, causing tremendous problems with liquidity [and] volatility,” Herzog Heine’s Geduld said.

The Internet-stock volatility has prompted NASD to form a committee to determine whether to implement a system to temporarily halt trading in stocks that gyrate wildly.

Yet others argue that the entry of so many new and active traders actually is good for the market overall--by adding liquidity, meaning it’s easier for investors to find other people who are willing to buy from, or sell to, them.

“If you took all the short-term traders and the day traders and completely removed them from the market, you’d have a tremendous liquidity crisis,” Mathisson said. “And then when you had an institution or a long-term investor that for whatever reason wanted to unload their position, in a lot of situations there wouldn’t be anyone to take the other side.”

What’s more, criticism of individual investors’ use of the same fast-paced trading strategies that many Wall Street pros have long employed strikes some analysts as classically elitist.

Individuals’ Trading ‘Is Here to Stay’

While day traders, regulators, Wall Street pros and average investors may continue to debate whether the rise of the individual trader is good or bad, most agree on one thing: The ranks of such traders will only grow.

The powerful technology that once was limited to Wall Street and now is commonplace among professional day traders is certain to become cheaper and more widespread. As that occurs, experts say, average investors’ urge to trade, as opposed to simply buying and holding, is bound to rise.

“Trading by individuals is here to stay because information and tools are now available to them, and they’re going to keep getting better,” said Rick Roberts, a former SEC commissioner who is now a private securities attorney representing several day-trading and online firms.

Indeed, greater access to technology means the current lines between professional day traders and at-home online investors will blur--a process already underway.

For example, Internet brokerage E-Trade last year began offering its most active customers so-called Level II screens, a prime day-traders’ tool. And last month, E-Trade and white-shoe Wall Street firm Goldman, Sachs & Co. each bought 25% stakes in an electronic communications network, or ECN, an independent trading network that matches buyers and sellers.

Though a prolonged bear market probably would depress small investors’ inclination to trade, even that won’t stop it, experts argue.

What is more human, traders say, than wanting to take a chance, to gamble for a possible huge payoff? And if that means the stock market becomes more like Las Vegas for more investors, does the government have any business trying to stop that?

“You do hear stories about people who have been trading for all of six months and then they quit their job and invest their life savings,” said Mathisson. “Those people are foolish, and there will always be foolish people, and you can’t regulate away foolishness.”

Walter Hamilton can be reached by e-mail at walter.hamilton@latimes.com.