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It seems like a no-brainer to me:

  1. Find a cheap stock with a good name (Dell, FB, Sony) that fluctuates by a few dollars per day
    (between -$2 and +$2), and is consistent in the fluctuation throughout the past few months.
  2. Buy 100 shares (or as much as you can afford to risk) using a limit order of the lowest fluctuation (between -$2 and -$1).
  3. Sell all the shares using a limit order of any amount between $1 to $2 above your original purchase price.

What are the downsides of this investment strategy? How can this strategy be improved?

EDIT


John Bensin, pretty much answered most of my concerns. However, I never specified that the trades have to be done within the same day. Also, according to my "algorithm" a sale only takes place once the stock rises by 1 or 2 points; otherwise the stock is held until it does. So to revise:

  1. Let the investor open up 5 brokerage accounts at 5 different firms (for safeguarding against being labeled a "Pattern Day Trader").
  2. Each account may only hold 1 security at any time, for the span of 1 business week.
  3. Once the funds settle--this usually takes up to 5 business days--place a limit sale order, of any amount between $1 to $2 above your original purchase price .

Assuming one has the funds, couldn't such a system generate some sort of passive income? Having 5 securities at one time benefits from diversification. Of course a bigger number would be preferable.

To address the commission fee problem, assuming a fee of $8 per trade (I was actually able to find firms with fees ranging from $4 to $5 per trade), and a minimum of $100 profit per sale, we get $100 - $16 (1 buy, 1 sell) = $84. Still acceptable.

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    It's usually best to wait a couple of days before accepting an answer, because although I do like my answer, waiting a few days gives other people a chance to answer and gives you a better chance of getting a wider range of information about your question. – John Bensin Aug 8 '13 at 13:56
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    have you tried this strategy or at least simulated it? – mhoran_psprep Aug 8 '13 at 18:20
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    @Ramin Google Finance isn't a backtesting tool, and I wouldn't substitute looking at a chart for data analysis. I mentioned margin calls because you probably will get a margin call if you day trade in your brokerage account and don't fund it with the minimum (usually $25,000). See point 2 in my answer below. – John Bensin Aug 8 '13 at 23:02
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    Isn't this called channeling stocks? Or range trading? Once a pattern is obvious, it stops working. – Randy Aug 9 '13 at 9:39
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    @Ramin A better system would be to buy only ETFs that pay dividends (if you plan to hold forever until you get your 1 or 2 points). ETFs won't go to zero like stocks can and you get paid something for holding it forever. Also, what if the ETF rises 3 points that same day? Its awful tempting to take it... especially when you KNOW the stock will be down tomorrow. And then, if you do sell for +3, how do you know when to get back in? Do you sit in cash and wait forever for a decline? Or do you buy again at the same or higher price as you just sold? I've been wrestling with these decisions 10yrs. – Randy Aug 9 '13 at 18:32
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Yes. There are several downsides to this strategy:

  1. You aren't taking into account commissions. If you pay $5 each time you buy or sell a stock, you may greatly reduce or even eliminate any possible gains you would make from trading such small amounts. This next point sounds obvious, but remember that you pay a commission on every trade regardless of profit, so every trade you make that you make at a loss also costs you commissions. Even if you make trades that are profitable more often than not, if you make quite a few trades with small amounts like this, your commissions may eat away all of your profits. Commissions represent a fixed cost, so their effect on your gains decreases proportionally with the amount of money you place at risk in each trade.

  2. Since you're in the US, you're required to follow the SEC rules on pattern day trading. From that link, "FINRA rules define a “pattern day trader” as any customer who executes four or more “day trades” within five business days, provided that the number of day trades represents more than six percent of the customer’s total trades in the margin account for that same five business day period." If you trip this rule, you'll be required to maintain $25,000 in a margin brokerage account. If you can't maintain the balance, your account will be locked.

  3. Don't forget about capital gains taxes. Since you're holding these securities for less than a year, your gains will be taxed at your ordinary income tax rates. You can deduct your capital losses too (assuming you don't repurchase the same security within 30 days, because in that case, the wash sale rule prevents you from deducting the loss), but it's important to think about gains and losses in real terms, not nominal terms. The story is different if you make these trades in a tax-sheltered account like an IRA, but the other problems still apply.

  4. You're implicitly assuming that the stock's prices are skewed in the positive direction. Remember that you have limit orders placed at the upper and lower bounds of the range, so if the stock price decreases before it increases, your limit order at the lower bound will be triggered and you'll trade at a loss. If you're hoping to make a profit through buying low and selling high, you want a stock that hits its upper bound before hitting the lower bound the majority of the time. Unless you have data analysis (not just your intuition or a pattern you've talked yourself into from looking at a chart) to back this up, you're essentially gambling that more often than not, the stock price will increase before it decreases.

  5. It's dangerous to use any strategy that you haven't backtested extensively. Find several months or years of historical data, either intra-day or daily data, depending on the time frame you're using to trade, and simulate your strategy exactly. This helps you determine the potential profitability of your strategy, and it also forces you to decide on a plan for precisely when you want to invest. Do you invest as soon as the stock trades in a range (which algorithms can determine far better than intuition)? It also helps you figure out how to manage your risk and how much loss you're willing to accept. For risk management, using limit orders is a start, but see my point above about positively skewed prices. Limit orders aren't enough.

In general, if an active investment strategy seems like a "no-brainer" or too good to be true, it's probably not viable. In general, as a retail investor, it's foolish to assume that no one else has thought of your simple active strategy to make easy money. I can promise you that someone has thought of it. Trading firms have quantitative researchers that are paid to think of and implement trading strategies all the time. If it's viable at any scale, they'll probably already have utilized it and arbitraged away the potential for small traders to make significant gains.

Trust me, you're not the first person who thought of using limit orders to make "easy money" off volatile stocks. The fact that you're asking here and doing research before implementing this strategy, however, means that you're on the right track. It's always wise to research a strategy extensively before deploying it in the wild.


To answer the question in your title, since it could be interpreted a little differently than the body of the question: No, there's nothing wrong with investing in volatile stocks, indexes, etc. I certainly do, and I'm sure many others on this site do as well. It's not the investing that gets you into trouble and costs you a lot of money; it's the rapid buying and selling and attempting to time the market that proves costly, which is what you're doing when you implicitly bet that the distribution of the stock's prices is positively skewed.

Update (In response to your edit:)

To address the commission fee problem, assuming a fee of $8 per trade ... and a minimum of $100 profit per sale

Commissions aren't your only problem, and counting on $100 profit per sale is a significant assumption. Look at point #4 above. Through your use of limit orders, you're making the implicit assumption that, more often than not, the price will trigger your upper limit order before your lower limit order.

Here's a simple example; let's assume you have limit orders placed at +2 and -2 of your purchase price, and that triggering the limit order at +2 earns you $100 profit, while triggering the limit order at -2 incurs a loss of $100. Assume your commission is $5 on each trade.

If your upper limit order is triggered, you earn a profit of 100 - 10 = 90, then set up the same set of limit orders again. If your lower limit order is triggered this time, you incur a loss of 100 + 10 = 110, so your net gain is 90 - 110 = -20. This is a perfect example of why, when taking into account transaction costs, even strategies that at first glance seem profitable mathematically can actually fail.

If you set up the same situation again and incur a loss again (100 + 10 = 110), you're now down -20 - 110 = -130. To make a profit, you need to make two profitable trades, without incurring further losses.

This is why point #4 is so important. Whenever you trade, it's critical to completely understand the risk you're taking and the bet you're actually making, not just the bet you think you're making.

Also, according to my "algorithm" a sale only takes place once the stock rises by 1 or 2 points; otherwise the stock is held until it does.

Does this mean you've removed the lower limit order? If yes, then you expose yourself to downside risk. What if the stock has traded within a range, then suddenly starts declining because of bad earnings reports or systemic risks (to name a few)? If you haven't removed the lower limit order, then point #4 still stands.

However, I never specified that the trades have to be done within the same day.

Let the investor open up 5 brokerage accounts at 5 different firms (for safeguarding against being labeled a "Pattern Day Trader").

Each account may only hold 1 security at any time, for the span of 1 business week.

How do you control how long the security is held? You're using limit orders, which will be triggered when the stock price hits a certain level, regardless of when that happens. Maybe that will happen within a week, or maybe it will happen within the same day. Once again, the bet you're actually making is different from the bet you think you're making.

Can you provide some algorithms or methods that do work for generating some extra cash on the side, aside from purchasing S&P 500 type index funds and waiting?

When I purchase index funds, it's not to generate extra liquid cash on the side. I don't invest nearly enough to be able to purchase an index fund and earn substantial dividends.

I don't want to get into any specific strategies because I'm not in the business of making investment recommendations, and I don't want to start. Furthermore, I don't think explicit investment recommendations are welcome here (unless it's describing why something is a bad idea), and I agree with that policy. I will make a couple of points, however.

  1. Understand your goals. Are you investing for retirement or a shorter horizon, e.g. some side income? You seem to know this already, but I include it for future readers.

  2. If a strategy seems too good to be true, it probably is.

  3. Educate yourself before designing a strategy. Research fundamental analysis, different types of orders (e.g., so you fully understand that you don't have control over when limit orders are executed), different sectors of the market if that's where your interests lie, etc. Personally, I find some sectors fascinating, so researching them thoroughly allows me to make informed investment decisions as well as learn about something that interests me.

  4. Understand your limits. How much money are you willing to risk and possibly lose? Do you have a risk management strategy in place to prevent unexpected losses? What are the costs of the risk management itself?

  5. Backtest, backtest, backtest. Ideally your backtesting and simulating should be identical to actual market conditions and incorporate all transaction costs and a wide range of historical data.

  6. Get other opinions. Evaluate those opinions with the same critical eye as I and others have evaluated your proposed strategy.

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    @Ramin Schwab accounts do have minimum balance requirement if you meet their definition of a pattern day trader. Also, you're assuming that you'll make a positive gain on every trade. Every trade you make that *doesn't result in a gain will also cost you commissions, so if you're making a lot of trades at small amounts, these amounts can become significant even if a few of your trades result in gains. – John Bensin Aug 8 '13 at 13:11
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    ah thanks for finding that. OptionsHouse has a better disclaimer: optionshouse.com/risk/pattern – TheOne Aug 8 '13 at 13:18
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    How does the wash sale rules fit into this. If the OP sells stock X for a loss, there is the 61 day (-30 to + 30) window where if the same stock is repurchased that will defer the loss. – mhoran_psprep Aug 8 '13 at 19:27
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    @Chelonian It basically just means that they'll already have used that strategy, and when the market reacts to the intense buying/selling pressure within that range, it may start trending one way or another and the range strategy won't work. Basically, my general warning with simple strategies is that you shouldn't assume a trading firm hasn't acted on it, because they can always trade faster than you. As for a margin call, I mean that you will literally receive a call from your broker saying "you need to put a minimum balance into your account." – John Bensin Aug 9 '13 at 11:09
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    @JohnBensin No its an SEC rule. I've been a pattern daytrader since 2003. After the 4 round trips in 5 days, you make a 5th and get the call. Broker says "don't do it again". 10yrs later you decide to make 1 daytrade, your account locks to closing positions only until you send in enough to bring up to $25k. They may let you reopen as a cash account, but to have a margin account means switching brokers so the new broker can swear he didn't know you were a daytrader because no such pattern has been observed. Once broker labels you, its for life due to the SEC rule. – Randy Aug 9 '13 at 17:57
5

Its hard to write much in those comment boxes, so I'll just make an answer, although its really not a formal answer.

Regarding commissions, it costs me $5 per trade, so that's actually $10 per trade ($5 to buy, $5 to sell). An ETF like TNA ($58 per share currently) fluctuates $1 or $2 per day. IXC is $40 per share and fluctuates nearly 50 cents per day (a little less). So to make any decent money per trade would mean a share size of 50 shares TNA which means I need $2900 in cash (TNA is not marginable). If it goes up $1 and I sell, that's $10 for the broker and $40 for me. I would consider this to be the minimum share size for TNA. For IXC, 100 shares would cost me $4000 / 2 = $2000 since IXC is marginable. If IXC goes up 50 cents, that's $10 for the broker and $40 for me. IXC also pays a decent dividend. TNA does not. You'll notice the amount of cash needed to capture these gains is roughly the same. (Actually, to capture daily moves in IXC, you'll need a bit more than $2000 because it doesn't vary quite a full 50 cents each day).

At first, I thought you were describing range trading or stock channeling, but those systems require stop losses when the range or channel is broken. You're now talking about holding forever until you get 1 or 2 points of profit. Therefore, I wouldn't trade stocks at all. Stocks could go to zero, ETFs will not. It seems to me you're looking for a way to generate small, consistent returns and you're not seeking to strike it rich in one trade. Therefore, buying something that pays a dividend would be a good idea if you plan to hold forever while waiting for your 1 or 2 points.

In your system you're also going to have to define when to get back in the trade. If you buy IXC now at $40 and it goes to $41 and you sell, do you wait for it to come back to $40? What if it never does? Are you happy with having only made one trade for $40 profit in your lifetime? What if it goes up to $45 and then dips to $42, do you buy at $42? If so, what stops you from eventually buying at the tippy top? Or even worse, what stops you from feeling even more confident at the top and buying bigger lots? If it gets to $49, surely it will cover that last buck to $50, right? /sarc

What if you bought IXC at $40 and it went down. Now what? Do you take up gardening as a hobby while waiting for IXC to come back? Do you buy more at lower prices and average down? Do you find other stocks to trade? If so, how long until you run out of money and you start getting margin calls? Then you'll be forced to sell at the bottom when you should be buying more.

All these systems seem easy, but when you actually get in there and try to use them, you'll find they're not so easy. Anything that is obvious, won't work anymore. And even when you find something that is obvious and bet that it stops working, you'll be wrong then too. The thing is, if you think of it, many others just like you also think of it... therefore it can't work because everyone can't make money in stocks just like everyone at the poker table can't make money. If you can make 1% or 2% per day on your money, that's actually quite good and not too many people can do that. Or maybe its better to say, if you can make 2% per trade, and not take a 50% loss per 10 trades, you're doing quite well.

If you make $40 per trade profit while working with $2-3k and you do that 50 times per year (50 trades is not a lot in a year), you've doubled your money for the year. Who does that on a consistent basis? To expect that kind of performance is just unrealistic. It much easier to earn $2k with $100k than it is to double $2k in a year. In stocks, money flows TO those who have it and FROM those who don't.

You have to plan for all possibilities, form a system then stick to it, and not take on too much risk or expect big (unrealistic) rewards.

Daytrading

You make 4 roundtrips in 5 days, that broker labels you a pattern daytrader. Once you're labeled, its for life at that brokerage. If you switch to a new broker, the new broker doesn't know your dealings with the old broker, therefore you'll have to establish a new pattern with the new broker in order to be labeled. If the SEC were to ask, the broker would have to say 'yes' or 'no' concering if you established a pattern of daytrading at that brokerage.

Suppose you make the 4 roundtrips and then you make a 5th that triggers the call. The broker will call you up and say you either need to deposit enough to bring your account to $25k or you need to never make another daytrade at that firm... ever! That's the only warning you'll ever get. If you're in violation again, they lock your account to closing positions until you send in funds to bring the balance up to $25k. All you need to do is have the money hit your account, you can take it right back out again. Once your account has $25k, you're allowed to trade again.... even if you remove $15k of it that same day. If you trigger the call again, you have to send the $15k back in, then take it back out.

Having the label is not all bad... they give you 4x margin. So with $25k, you can buy $100k of marginable stock. I don't know... that could be a bad thing too. You could get a margin call at the end of the day for owning $100k of stock when you're only allowed to own $50k overnight. I believe that's a fed call and its a pretty big deal.

  • Good answer. You covered a lot of details that I didn't discuss in depth. (and since it's your first answer, welcome to money.SE. Stick around!) – John Bensin Aug 9 '13 at 20:17
  • Are ETFs more in line with my goals (to make short term gains) than investing in traditional total market index funds? – TheOne Aug 9 '13 at 21:24
  • @JohnBensin Thanks! I would have said more, but it seems I hit some kind of character limit. – Randy Aug 10 '13 at 1:00
  • @Ramin This is another question all to itself and I'm finding not enough room again to explain. Index funds track an index, like TNA I mentioned tracks the russell 2000 (it does it at 3x daily leverage though). IWM tracks the russell 2000 also and with no leverage. IXC doesn't track an index (that I know of), but it may as well. IXC is a basket of energy and oil related stocks. Regardless of whether they track indices or not, they're still a basket of stocks. If you look back at the price action, you should be able to determine what level of volatility there has been and then how to trade it. – Randy Aug 10 '13 at 1:08
  • @Randy What character limit do you hit? As you can tell, my post is much longer, so I'm surprised that you were limited and I wasn't (and I've posted extremely long answers elsewhere too). – John Bensin Aug 10 '13 at 1:52
5

Eventually, you'll end up buying a stock at or near a high-water mark. You might end up waiting a few years before you see your "guaranteed" $100 profit, and you now have $5K to $10K tied up in the wait. The more frequently you trade, the faster your money gets trapped. There are two ways to avoid this problem:

1) Do it during strong bull markets.
    If everything keeps going up you don't need to worry about peaks...but then why would you keep cashing out for $1 gains?

2) Accurately predict the peaks.
    If you can see the future, why would you keep cashing out for $1 gains?

Either way, this strategy will only make your broker happy, $8 at a time.

-1

The strategy has intrinsic value, which may or may not be obstructed in practice by details mentioned in other answers (tax and other overheads, regulation, risk). John Bensin says that as a general principle, if a simple technical analysis is good then someone will have implemented it before you. That's fair, but we can do better than an existence proof for this particular case, we can point to who is doing approximately this.

Market makers are already doing this with different numbers. They quote a buy price and a sell price on the same stock, so they are already buying low and selling high with a small margin. If your strategy works in practice, that means you can make low-risk money from short-term volatility that they're missing out on, by setting your margin at approximately the daily price variation instead of the current bid-offer spread. But market makers choose their own bid-offer spread, and they choose it because they think it's the best margin to make low-risk money in the long run. So you'd be relying that:

  • market makers haven't already squeezed all such profit out of the market. Which is strictly speaking true, market makers aren't all-powerful.
  • You, as a private trader, can get in and find that profit without excessive risk. Which is almost certainly false. Firstly because no matter how cheap a brokerage deal you find, Big Investment can find cheaper deals and designated market makers might actually have special privileges depending what exchange you choose. Secondly because they monitor the market more closely, which is kind of important for any trading strategy based on technical analysis rather than fundamental analysis. They change their buy and sell prices over time for a reason, and that reason is not to make the long-term returns of their strategy worse than yours!

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