Margin Madness Fosters Dangerous Daytrading

Some daytrading firms will lend clients 10 times their capital 'on margin,' sometimes at exorbitant interest rates.
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It may start with a television commercial, one lucky stock pick or dreams of easy money. The risk of losing it all may be no more than an afterthought that comes when the money is gone.

But members of the daytrading community say their work can be extremely costly for beginners with little market knowledge, money in their pockets and the promise of margin loans. Daytrading strategies -- buying or selling on movements as small as 1/8 -- don't necessarily end in large losses, but experts say it takes many months to learn the business before beginners can get close to making money.

"If you go in with no clue how to do it, it's no different than betting on red or black," says Dave Floyd, a partner at Web site

Careerdaytrader.com

and a full-time trader for the past six years in San Diego.

It's still unclear how much finances played a role in Thursday's

killings at two Atlanta daytrading offices. The alleged gunman, Mark Barton, had lost $100,000 or more in recent days trading, according to

WXIA-TV

in Atlanta. But it's clear that Barton also had plenty of other problems, making him an extreme example. He also apparently killed his family and was the key suspect in two murders six years ago. In his suicide note, he said he had been dying since October, according to published reports.

Whatever Barton's motives may have been, the incident has focused attention on daytrading, a bull-market phenomenon that has attracted a slew of newcomers to a business that professionals say has the inherent danger of losing it all, or more.

Daytraders say that not all daytrading firms are alike. Some are more professional than others, catering to experienced traders. In a move not related to the shootings, the

Electronic Traders Association

, a daytrading trade group, on Thursday released a statement of ethical principles. Some of the practices that worry regulators are addressed, such as not making misleading or exaggerated claims about a firm's services or the benefits of daytrading.

But there remain plenty of risks, chief among them leverage, or borrowing money to trade. The results of a bad trade, or a good trade, naturally get exacerbated when the trader uses leverage to buy the stocks. Based on

Federal Reserve Board

rules, investors can borrow up to 50% of the value of a stock they are buying. That's open to any investor, Floyd points out.

But in some cases, traders and experts say, daytrading firms have exploited a 1996 amendment to the Fed's "Regulation T" that enables them to arrange for funds from another lender. That has meant leverage as high as 5-to-1, or even 10-to-1 at some firms that are manipulating that rule.

Jon Najarian, chairman of

Mercury Trading

, a major options trading firm based in Chicago, says daytraders need to understand how margin works and to be cognizant of lending rates. Brokers can't allow investors more than 2-to-1 margin, he says. "But they may have a finance arm, acting as loan shark, that will lend you 10 times your capital at 20% interest."

In such a scenario, the losses pile up quick. "Let's say you have a $25,000 account," Najarian says. "You leverage it using margin to $50,000. But the firm lends you up to $250,000.

"You buy 1,000 shares of

Onsale

(ONSL)

, for example, and it drops $4. If you aren't investing on margin, you've only lost $4,000, and you're down to $21,000 in your $25,000 account. But if you're trading at five times leverage, let's say, you've lost $20,000, nearly your whole account, on a $4-move in one stock," he says.

"If it were my firm, I wouldn't allow traders to invest on margin for at least three months, sort of like training wheels," Najarian says.

That wasn't the case for John Skiersch, 33, a former Chicago-based daytrader. He says that at the two daytrading firms he was at from 1997 through mid-1998 his borrowing extended beyond the legal limit, with the firms essentially fronting him the money. Skiersch believes he lost more than $320,000 in the year that he was trading but that the firms refused to supply him with trade confirmations to verify the numbers.

"I was told that the access to the markets and the technology was so good that there was no way that the huge giant brokerage houses could compete. It was just a matter of getting in here and pulling the trigger on the mouse," Skiersch says.

At the first firm he signed up with, Skiersch says, the only disclosure the firm made was that daytrading would incur a higher volume of trades and commissions than at traditional firms. Skiersch left trading after his account was closed on a margin call and the firm wanted him to sell his car to put up the money.

A margin call is when the brokerage forces you to deposit additional money in your account as collateral against the margin loan because the value of that position has fallen with the stock price.

Regulators, including the

Securities and Exchange Commission

, are investigating daytrading firms and online brokerages for broad compliance issues. The

National Association of Securities Dealers

on Thursday said it would propose a rule to the SEC setting out disclosure guidelines. And the

North American Securities Administrators Association

, which includes state regulators, has assembled a task force that is due to release a report next month.

"I totally disagree with the aggressive lending" done by these firms, says David Nassar, who runs

Market Wise Trading

in Colorado, which specializes in training daytraders. He's also the author of

How To Get Started in Electronic Day Trading

.

"This is not about margin. It's about knowledge, about people knowing what they're doing, like skydiving or anything that's risky," he says. "Disciplined traders know why they're getting in and out. Brokerage firms know to turn down accounts before bringing on the problem customer."

In some firms, the daytrading community argues, that's the case. For example, San Diego trader Floyd works with a group of a few friends he has known for years. Skiersch, however, says he was trading in a room of about 100 people, most of them neophytes who had gone through the same one-day trading course that he took.

"The problem is that everyone is new," he says. "There's always the excitement of rookies. The wise old people who have learned the hard way are gone."