There is a wide rift between day trading/technical analysis and the academia. It boils down to the efficient market hypothesis which you can read more about here. To many academics, day traders are noise traders, and technical analysis is at best voodoo.
As a result, we don’t talk to each other. Day traders stare at their trading charts. Finance professors ramble on in front of college students while trying to get their research into respectable journals. The exchange of ideas is minimal.
However, there are some finance researchers who tried to explore the realm of day trading. We have condensed their rigorous research into 3 top lessons for day traders.
1. Emotions Affect The Performance of Day Traders
Fear and Greed in Financial Markets: A Clinical Study of Day-Traders by Andrew W. Lo, Dmitry V. Repin, and Brett N. Steenbarger
I wish there are more studies with this awesome combination of authors: two well-published finance professors from MIT Sloan School of Management and a leading trading psychologist.
The conclusions of this study include:
- Extreme emotions make you earn less
- External factors affect your emotions
We have always heard that managing your emotions is critical for day traders. This study confirms that claim. Day traders who are more emotionally detached from their wins and losses do better than those who react strongly to each trade outcome.
Apparently, Stoics make good day traders.
The paper also pointed out that external factors like the weather, market events, and family history affect an individual’s emotional context. This is a reason to be more aware of your emotional response to external events, and know when you should avoid trading.
2. Performance of Technical Analysis
The Profitability of Technical Analysis: A Review by Cheol-Ho Park and Scott H. Irwin
This paper is probably the most comprehensive literature review of the profitability of technical analysis. The authors reviewed more than 100 studies on how profitable technical trading rules are.
As most day traders use technical analysis, this paper presents valuable information.
The studies reviewed showed that technical analysis seem to work better in forex and futures markets. In addition, according to survey studies, the use of technical analysis is widespread in forex and futures markets. You might want to consider this when you decide which market to day trade.
Discuss: Why You Should Day Trade Futures
However, the authors pointed out that most performance studies have errors like data snooping. As these studies used mechanical trading rules, this is a stark warning against mechanical trading systems that promises incredibly high win rates.
3. Profitability of Day Traders
How many times have you heard that 90% of day traders lose money? Have you wondered if there’s any basis to that?
Here’s the answer.
Day Trading by Martin Sewell
Martin Sewell from University College London compiled a concise list of studies conducted between 1998 and 2005 on how profitable day traders are. The day traders examined are from US, Taiwan, and Finland.
From those studies, Martin Sewell concluded that 70% to 80% of day traders lose money.
The good news is that 90% overstates the failure rate of day traders. At least according to these studies from different countries around the world.
The bad news is that 70% to 80% is still rather high. To a struggling or aspiring day trader, these numbers are not encouraging. But I don’t see why they should be anyway.
The reality is that day trading is challenging. And it is definitely not a way to get rich quick. These studies remind you of this reality.
The Caveats In These Lessons
These research have definitely offered day traders some basis and perspectives related to many conventional trading wisdom floating around out there.
However, absorb them with care. Each study has its own assumptions, samples, methodology. Each conclusion stands only the face of these limitations. Always refer to the original papers for details.
Finally, remember that trading fuses art and science, and not all aspects of trading is quantifiable. Stay open-minded and gain more trading experience to learn to hone your trading gut.
Image credit: John Walker [CC BY 2.0] via Flickr (cropped from original)
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