Today we start a 3-part series that draws the trendline on the art of trading itself. Specifically we’ll share why scalping as the veterans know it is over and how the rebirth of day trading leverages technology and accessible information to put the individual trader on the same footing as any hedge fund manager. The 3rd part of the series concludes our idea for a future WallStrip segment.

Part 1: The Death of Scalping

SOES Bandits Take the Easy Money

I started day trading in 1995.

Back then there was a real information arbitrage in how orders were executed on the Nasdaq. When I was learning to trade, SOES and Select-Net allowed us, the day traders, to have a slight edge on the market makers when executing orders of 1000 shares or less. It was real, and it worked. Not only did traders make money, but a whole industry was born out of it. Block Trading (where I got my start), Cornerstone Securities, Momentum Trading, and Harvey Houtkin’s All Tech thrived. This was before the ECN’s and before direct access software.

The style of trading that made the most sense in that environment was a style called “Scalp Trading“. You would buy 1000 shares on one network, typically SOES and then sell the same thousand on another network, typically Select-Net, to market makers who were trying to reduce their risk. In quickly and out quickly in seconds, that was the name of the game.

The One Direction Market

As the market started on its long road up some of the traders at the firms were noticing that they could make more money with another style of trading. It was called position trading and it was conceptually simple. Identify the prevailing trend and press your bets – sometimes holding positions several days and being in as many positions as risk allowed. As it turned out, this style of trading lead to the biggest volume increase for day trading firms. Quickly it was evident that good software had to be built around this new, more technically, focused trading. Enter CyberTrader, TradeCast, Gr8Trade, and TradeScape. All of these software products were built around the day trader. The software made it possible to manage multiple positions at once, track risk, and execute strategies very quickly when opportunities presented themselves.

As the markets pushed higher and higher fueled by the dot com mania, most investors and would-be traders got the idea, pushed by the media, that day traders were people who had accounts with E*trade and Ameritrade and bought stocks and held them and got rich. People who became interested in the markets ran to open up their accounts at these big brokers and started trading. They did this and we saw the commercials, but it is important to point out that this group was really not the day traders. They were the weekend warrior investor trying to jump in on a trend.

The professional traders were still trading at offices mostly sitting in front of trading terminal during market hours looking to exploit some strategy. The more successful of them that I got to see in person were leveraging the position style of trading to get the kind of returns I never though were possible. I saw first hand guys in Austin, Texas have 100K, 200K, and some even 500K days. They pressed longs at the right time, when stocks like Yahoo and Ebay and Dell were unstoppable, and that is just to name a couple.

Fast forward. When the mainstream got wind of what was going on at the day trading firms, specifically how this software makes it possible for traders to trade a whole lot more than ever thought possible, most of the firms were bought out.

#1 CyberTrader – 400 Million Plus – Schwab
#2 TradeScape – 300 Million Plus – E*Trade
#3 ProTrader – 150 Million – Instinet
#4 TradeCast – 60 Million – Ameritrade

After the WipeOut, A Chance at a Balboa-like Comeback

There were many others. But as the market got closer and closer to 2000 and the trend not as clearly identifiable many of the day traders simply kept doing what they did before, pressing their bets and losing a lot of money quickly. A large number was never able to adjust and got wiped out. As the market plunged and trading ranges got more narrow an old school type of trading became more and more viable in the day trading world.

The business although much smaller after the dot com bubble days never faded. Offices all over the US and even overseas continued to run. Now traders got back to what they did before the dot com bubble started. In fast and out fast. Trading ranges were defined and the trend was down. Those who were savvy at trading the downside were rewarded quickly. Scalp trading was reborn and thrived.

The problem with scalp trading is that it is very specific to a certain kind of person.

It is more art than science and you really have to have a good feel for the market and reading the tape. It requires a lot of skills that can be acquired through the school of hard knocks but are really almost impossible to teach. It doesn’t compare well to the other trading methods that exist today. The average churn within professional trading firms falls far short of the time it takes to practice and master the scalping art. That is why as the dot com bubble burst it sounded like the death of day trading. The people that still traded professionally were very savvy and fairly few in numbers compared to the hey days of mid to late 90’s.

Wednesday we’ll discuss what’s behind the rebirth of day trading and why there’ll be more people at it with a better chance of doing better than before.