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The plight of the (undercapitalized) day trader

These days, everyone seems to proclaim a theory about making money trading the markets. Though some people certainly do it and succeed amazingly, I’d wager that most aspiring traders are on the losing side of the game.

Lets face it, for every winner, there has to be at least one loser, and though it’s often pointed out that index investing beats the performance of the majority of portfolio managers, it’s rarely pointed out that for most individuals, trading is a losing proposition in and of itself, and instead we just hear that “buy and hold” investing is dead.

It’s never pointed out that “buy and hold is dead” is only the view point that the brokers who stand to gain from transaction fees, margin lending, hard-to-borrow fees, etc wish to have pushed. I mean, they run ads on nearly every financial news website, not to mention during every commercial break on CNBC, while outfits like Vanguard spend comparatively little, so espousing a viewpoint  that doesn’t fit into the rapid turnover world they want is akin to biting the hand that feeds them advertising revenues.

Assuming a 5% paltry yet average rate of return on equity investments, 2% annual dividends, and a 15% tax rate on those dividends, and no portfolio turnover, an investor who buys and holds an index fund in a taxable account can expect a 6.7% rate of return, which doesn’t sound very impressive. That result can be replicated whether the investor has $100 or $1,000,000 in working capital.

The trader face headwinds in a few tangible ways.

First, with 250 trading days per year, and making just 4 trades per day (or, two round trip day trades), and paying $4.50 per trade, they’ve got a $4,500 annual drag on their portfolio.

Second, by rapidly realizing profits and losses, they confine all of their income to the short-term capital gains category, which is taxed at the highest rate.

I prepared a spreadsheet to examine a few possible outcomes:

The buy-and-hold type (6.7% total ROR)

Starting balance                $200,000
5% growth                          $10,000
2% dividend                       $4,000
(15% tax on div)                                (-$600)
End balance                        $213,400

The well-capitalized trader (12.36% ROR to match buy and hold

Starting balance                $200,000
Trade Commissions         (-$4,500)
Required Trading gains  $24,165
ST Cap Gains tax               (-6,265)
End Balance                        $213,400

So, even a well capitalized trader faces a bit of a headwind, not to mention time spent trading and looking for opportunities. There’s no shortage of rags to riches stories about traders who discovered a magical trading formula. And those stories capture the hearts and dreams of less capitalized traders.

Many posters on internet forums lament the $25,000 minimum balance requirement to be a pattern day trader. Lets see what the trader with $25,000 faces. I’ll assume they’re not in the top tax bracket, but instead assume that they pay taxes at a 25% rate instead. And rather than making 2 day trades per day, I’ll assume one trade instead.

The buy-and-hold type
Starting balance                $25,000
5% growth                          $1,250
2% dividend                       $500
(15% tax on div)                                (-$75)
End balance                        $26,675

The under-capitalized day trader
Starting balance                $25,000
Trade Commissions         (-$2,250)
Required Trading gains  $4,906.25
ST Cap Gains tax               (-981.25)
End Balance                        $26,675

End result of making or averaging 1 day trade per day? The undercapitalized day trader needs to register returns of 21.57% in order to match the total after tax return by the buy and hold investor who returns a “paltry” 6.7% annually. And look at how much money you gave away to both your broker and Uncle Sam. Those aren't small numbers, especially once you compound them for a few years.

So, buy and hold may or may not be dead, but trading will certainly kill you all but a select few.

I know there are several successful traders in our midst. And this isn’t meant to bash them – if they can do it and turn decent profits, I applaud them. But I’d urge anyone who’s setting off to be a day trader through an online brokerage account to do themselves a favor and run the numbers a little bit first.

DISCLOSURE: No positions were mentioned