Personal Finance

Day trading is all about risk control

B. VENKATESH | Updated on July 02, 2011 Published on July 02, 2011

Investors should moderate unintentional risk using the core-satellite framework.

Brokerage firms typically charge low commission and offer free research recommendations for day trading. Some wonder why day trading is very popular among individual investors. The question is: Is such trading optimal for individuals?

This article discusses how indulgent individuals could subject their portfolio to unintentional risk unless they diligently apply rules while engaging in such trading. It also shows how individuals can moderate such risk using the core-satellite framework.

There is a scientific argument to support day trading — it is called fractals or self-similarity. According to this argument, stock price has similar pattern during the day, week, month or year.

That is, individuals viewing a stock price graph cannot easily identify if the time frame is intra-day, daily, monthly, weekly or yearly because price patterns of a stock are similar across time. If individuals can profitably take positions based on daily or weekly charts, the argument is that they can do just as well based on intra-day charts.

But it takes more than viewing chart patterns to generate profitable trades. The important element for successful trading, especially intra-day trades, is discipline. This requires individuals to craft a trading plan that includes the entry price, price objective and stop loss to moderate losses due to adverse price movements.

Now, all brokerage firms provide individual investors this basic trading plan. Disciplined trading is, however, never complete unless this plan is implemented diligently. Most individuals buy the stock based on the recommendation but never implement the stop loss rule. This can be attributed to a behavioural bias called Loss Aversion.

That is, individuals prefer to hold on to their losses but take their profits quickly. So, a trade set-up for the day typically becomes a delivery-based position because individuals do not use the stop loss rule. Such trading could subject the portfolio to risk.

Unintentional risks

Individuals typically have a capital constraint. This is because of the gap between the individual's salary or business income and her material aspiration level. This gap can be filled by investment cash flows- income and capital appreciation from investments.

The problem, however, is that investors do not always have the capital to generate the required investment income that could fill the gap. And it is this already constrained capital that is diverted to day trading. For one, day trading could end up in frequent losses, further depleting capital. For another, converting day-trades into delivery positions can skew asset allocation and subject the portfolio to higher risk.

To understand how day-trading contributes to portfolio risk, consider the core-satellite framework. The core portfolio typically has passive exposure to stocks and bonds and is rebalanced to align with the strategic asset allocation policy. The satellite portfolio has active exposure to assets such as stocks and commodities and strives to beat the benchmark index.

Now consider an individual who buys stocks for day-trading but extends the time horizon because the position has unrealized losses. Based on the core-satellite framework, this could often result in transferring the equity exposure from the satellite portfolio to the core portfolio. Over a period of time, an individual could have unintended equity exposure in the core portfolio. And such exposure could jeopardize her long-term investment objectives.

Individuals need not avoid day trading. It is imperative that they apply rules diligently. We call the first rule as the Sweat Test. If an individual sweats on her palm or feels nervous each time she takes a day-trading position, it is, perhaps, a sign that she is not emotionally well-suited for such trading.

For others who feel confident about moderating their day-trading emotions, we recommend that they allocate money for such trading within the satellite portfolio and apply strict stop loss rules to moderate losses. Typical allocation for day-trading could range between 5 and 10 per cent of the portfolio. Besides, it would be optimal not to plough-back all profits into subsequent trades.

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