A reader recently forwarded to us a trading style description used by a pro trader:
We believe there is potentially reduced risk and greater profit potential within the short-term swings of a market move, rather than the entire move itself. i.e. An investor could potentially earn less profit by holding a position for an entire long-term move versus if he/she bought and sold the short-term swings of that move. Not only could an investor potentially earn a higher return, but he/she could have potentially reduced trading risk because positions are never held overnight. All accounts are “flat”, with no positions at the end of each trading day. Our approach to the index markets is simple: Take small consistent profits while employing strict money management techniques. Statistics show that the probability of success is greater by taking smaller profits per trade rather that waiting for the “big winner.” Less risk is taken and trading capital is not tied up for long periods of time.
We have never seen this so-called statistical evidence. We have seen traders blow up with this philosophy. It sounds very similar to Long Term Capital Management (PBS Special on LTCM). How did they view trading and the markets? Consider this, from Ian Kaplan:
LTCM applied financial models that assumed that markets are logical and will always tend toward equilibrium. LTCM made huge financial bets, in thousands of market positions. For four years LTCM showed excellent returns. In the third and final act, LTCM crashed and burned, endangering the US financial system…LTCM ignored two underlying assumptions behind the market models they used: 1.) The models assumed that markets are always liquid (e.g., you can always sell an asset at a reasonable price). 2.) Markets tend toward equilibrium, where “mispricings” are corrected. During a market panic, liquidity dries up as investors move their money to safer investments. While market equilibrium may be true in the long run, there can be “mispricings” that can persist for periods of time long enough to lose five billion dollars. In the end much of the personal wealth of the LTCM founders was destroyed.
Sure it might “feel” like day trading or shorter term trading is less risky, but the performance data over 20+ years from top trend traders paints a different picture. They show clearly the survivors are the home run hitters. They are the consistent winners.
Why the Short-Term Argument Fails
The pitch for short-term trading rests on three claims: reduced risk from no overnight exposure, higher probability of success from smaller profit targets, and statistical evidence supporting smaller consistent profits over large winners. None of these claims survive examination.
The overnight risk claim is the weakest. It is true that being flat at the end of each day eliminates gap risk. It is not true that this makes short-term trading less risky overall. The transaction costs of entering and exiting positions multiple times per day, including commissions, bid-ask spreads, and slippage, accumulate at a rate that can exceed the gains from avoiding occasional overnight gaps. The Odean and Barber research on 88,000 investor accounts documented that the most actively trading investors underperformed the least active by 5.5% annually. Eliminating overnight gap risk at the cost of excessive transaction costs is a bad trade.
The probability of success claim is the statistical error that produces the LTCM comparison. It is true that a strategy targeting small consistent profits will have a higher win rate than a strategy targeting large infrequent wins. This is not evidence of superior risk management. It is evidence of the same payoff structure that destroyed LTCM. A system that produces frequent small wins and occasional catastrophic losses is not low-risk. It is a system that has hidden the risk in the tail rather than eliminated it. The strategy looks good until the tail event arrives. LTCM looked good for four years. The day trader’s system looks good until a market event that produces gaps, liquidity failures, or sustained adverse moves that the flat-by-day-end rule cannot protect against.
The “statistical evidence” claim has never been produced by proponents of short-term trading in any form that withstands scrutiny. The long-run performance data from audited trend following managers, the same data the pitch contrasts against, documents that the consistent survivors over 20+ years are the home run hitters. Not the traders taking small consistent profits. The managers who produced the largest long-run compounded returns held positions for weeks and months, accepted frequent small losses, and captured occasional very large gains. That is the statistical record. The claim that small consistent profits are statistically superior is asserted without evidence and contradicted by the evidence that exists.
The LTCM comparison is precisely the right one. LTCM was the institutional version of the same philosophy: small consistent profits from convergent strategies, with the apparent elimination of the risk of large losses. The risk was not eliminated. It was hidden in the tail. When the tail arrived, five billion dollars of client capital and most of the founders’ personal wealth were destroyed in weeks.
Frequently Asked Questions
Why is being flat at the end of each day not actually lower risk?
Because the costs of entering and exiting positions multiple times per day, commissions, bid-ask spreads, and slippage, accumulate faster than occasional overnight gap risk. The Odean and Barber study of 88,000 investor accounts found that the most active traders underperformed the least active by 5.5% annually. Eliminating overnight gap risk by adding multiple daily transaction costs is a bad tradeoff. The risk is not eliminated; it is converted from tail risk to steady transaction cost erosion.
What is wrong with targeting “small consistent profits” as a trading strategy?
A strategy targeting small consistent profits achieves its win rate by cutting exposure before large moves materialize, which produces frequent small wins but misses the large gains that drive long-run compounded returns. It also accepts the structural risk of the occasional large loss that a flat-by-day-end rule cannot prevent when markets gap, become illiquid, or move adversely overnight. The strategy hides the tail risk rather than eliminating it. LTCM’s four years of small consistent profits ended in a single catastrophic loss.
What does the 20-year performance record show about short-term versus long-term trading?
The audited multi-decade performance records of systematic trend following managers document that the consistent long-run survivors are managers who hold positions for weeks and months, accept frequent small losses, and capture occasional large gains. The day traders and short-term consistency seekers are not represented in the 20-year survivor lists because the approach does not produce durable compounded returns across full market cycles.
Trend Following Systems
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