NEW YORK (CNNfn) - Regulators started eyeing the day-trading industry last year, long before Mark Barton lost more than $400,000 at Momentum Securities and All-Tech and went on the rampage. But they've increased their scrutiny in 1999.
So far only a handful of states - Massachusetts, Texas, Indiana and Wisconsin - have closed actions against day trading companies. But following Barton's rampage and a report from the North American Securities Administrators Association Inc. that was highly critical of day trading, most are looking into the industry.
"Quite often the state regulators are the quickest to respond, because the activities are happening in our backyard," said Patricia Struck, administrator of Wisconsin's securities division. With the heightened scrutiny devoted to the industry, day trading will be a focus of the state securities regulators when they meet at the end of September in San Juan, she said.
State regulators highlight problems
The NASAA report, a review of 30 accounts at All-Tech's Boston office, concluded that 70 percent of day traders would ultimately lose all the money they risk. Only a little more than 10 percent of the traders made money, and even they faced higher risks than their rewards justified.
"Day trading has a lot of problems," Ronald Johnson, the consultant who compiled the NASAA report, said. Few of the traders he examined were actually cutting their losses quickly, one of the keys to the strategy, he found. Most traders were limiting their profits and letting their losses ride. "Their average losses were greater than their average gains. Now that's a surefire way of going broke."
Johnson says day trading is inherently flawed and that most investors looking to speculate would be better suited using other vehicles such as options. By day trading, he feels, traders leave themselves open to stock-specific risk of news breaking with the companies they're trading. They also expose themselves to the risk that the market will move against them.
"Most of these people can't tell which way the market is going any better than a coin flip," Johnson said. In fact, "70 percent of them can't even tell which way the market is going, because they're always on the wrong side." They miss out on any big gains a stock might generate by selling quickly, he said. Because they were taking small gains, one large loss often proved crippling, he found.
"It's easy to take small gains, but you better take small losses," he said. What's more, high trading commissions - $25 per trade at All-Tech, for instance - eat into any profits, he said. He doesn't think the results would be any different at other day trading companies. "The sample was taken at random at a branch office of one of the largest corporations in the industry. It certainly is representative."
Misleading advertising and lack of data
Yet day-trading companies often boast high success ratios. Though the industry plans to release its own profitability study next week, regulators say the companies have yet to back up claims in its marketing and on Web sites, which amounts to misleading advertising.
In its marketing material, All-Tech says 30 percent of traders who stick with the strategy are successful, for instance. Momentum Securities has said up to 70 percent of customers make money, the NASAA report said. But David Shellenberger, chief of licensing of the Massachusetts Securities Division and chairman of the group that produced Johnson's report, says he gets rebuffed when he asks for proof. "The industry cannot make claims without a reasonable basis," he said.
His division has examined all the day trading companies that operate in his state. He says the problems extend well beyond day trading being a bad strategy. They often accept unsuitable customers and arrange loans for them to meet margin calls, he said. Some day trading companies have manipulated accounts and let people trade each other's accounts, which violates investment-advisory laws.
"The problems appear to be pervasive," he said. "The vast majority of day trading firms we have looked at have resulted in complaints." Five of the six complaints in Massachusetts have been settled, typically with payments to the state's educational fund and a ban on the company operating in the state.
Jim Lee, president of Momentum and the industry trade group , said Massachusetts is on a witch hunt of sorts. "Have they done a sampling of Morgan Stanley or Charles Schwab or Merrill Lynch's customers over the same period?" he asked, though he thinks NASAA's study was well-intentioned. "What is clearly happening is that the states are by and large attempting to create new rules retroactively, through enforcement."
Shellenberger responded that added scrutiny is justified if it reveals problems He thinks most day trading companies take in new customers, make money off training them, then spit them out after they lose their investments.
"The revolving door may be implicit in this business," he said. Though day trading companies point out they want their customers to do well and keep generating commissions, that isn't happening, he said. "It may not be in the industry's interest for the customers to fail, but the customers apparently are failing none the less."
Other states are watching
Though Texas and Massachusetts have been the most active in regulating day trading, most other states have been watching the industry, even if it's not that big in the state. So the regulators weren't surprised by the results of Johnson's study. "Most of the things that were in the report we already knew," said Indiana Securities Commissioner Bradley Skolnik.
His division has brought one complaint against a day trading company, Self Trading Securities Inc., which still operates but has to submit to two on-site audits a year. The company hadn't registered properly and failed to file the necessary paperwork under state law.
"There were a number of regulatory problems that really raised red flags in our minds," he said. Like Struck in Wisconsin, who brought a similar action against another company, he felt the day trading company showed a lack of how to set up a business.
The road to riches
But the larger issue is that day trading is really a high-tech form of gambling, he continued, and the companies do not do a good job of making sure investors are well-suited for it.
If a wealthy person wants to risk money, all well and good, he said. But too many people are trading with their life savings, he said, and can't afford the risks they're taking on. "I think a good number of people have been misled into believing that day trading will put them on the road to riches," he said. "It's much more likely they're going to lose everything they put at risk."
The National Association of Securities Dealers Inc., Nasdaq's parent, started examining day trading in 1998. In August it proposed two new rules, one requiring day-trading companies to incorporate a risk disclosure statement and another obligating them to ensure day trading is a suitable strategy for their customers.
The rules are open to public comment, after which they have to be approved by the Securities and Exchange Commission. Many day trading companies have already started to require risk disclosure anyway.
So far the SEC hasn't brought any actions against day trading companies, but it has dispatched a special task force to visit day-trading companies. The auditors scrutinize the companies' records for both violations of securities law and to make sure they live up to claims about technical issues such as the capacity they can take. Reportedly, they are also looking for violations of short-selling rules. So far, it has yet to bring any actions.
"This is a very fluid time," SEC spokesman Chris Ullman said. "Our goal here is to sustain our process, which is to protect the investor, make sure they know what they're getting into, and that the people they're dealing with don't lie or get them into something they're not suited for."
Few customer complaints
Shellenberger, the Massachusetts regulator, concedes there have been few customer complaints about day trading companies. But that's often the case in securities-law enforcement, he said. "You normally only see the tip of the iceberg, and that's particularly true here." Customers who have lost money feel foolish and responsible for trading badly and won't come forward, he said.
Once day trading companies start being upfront about the risks involved, he thinks the fad will pass. Speculation isn't a good strategy for retail customers, he said, who are better off investing than trying to profit from quick changes in the market.
"I think anyone who is sophisticated would realize paying a commission to flip a coin is not good speculation." He thinks day trading is a fad that will "disappear within a year or two," he said. "It's a poor way to deploy one's capital."