Day trading means buying and selling a batch of securities within a day, or even within seconds. It has nothing to do with investing in the traditional sense. It is exploiting the inevitable up-and-down price movements that occur during a trading session.
Day trading is most common in the stock markets and on the foreign exchange (forex) where currencies are traded.
Day traders are typically well-educated in the minutia of trading and tend to be well funded. Many of them add an additional level of risk by using leverage to increase the size of their stakes.
Day traders are attuned to events that cause short-term market moves. Trading based on the news is one popular technique. Scheduled announcements such as the release of economic statistics, corporate earnings, or interest rate announcements are subject to market expectations and market psychology. That is, markets react when those expectations are not met or are exceeded—usually with sudden, significant moves which can greatly benefit day traders.
Day traders use numerous intraday strategies. These strategies include:
- Scalping:This strategy focuses on making numerous small profits on ephemeral price changes that occur throughout the day.
- Range trading: This strategy uses pre-determined support and resistance levels in prices to determine the trader’s buy and sell decisions.
- News-based trading: This strategy seizes trading opportunities from the heightened volatility that occurs around news events.
- High-frequency trading (HTF): These strategies use sophisticated algorithms to exploit small or short-term market inefficiencies.
The profit potential of day trading is an oft-debated topic on Wall Street. Internet day-trading scams have lured amateurs by promising enormous returns in a short period of time.
Some people day-trade without sufficient knowledge. But there are day traders who make a successful living despite—or perhaps because of—the risks.
Many professional money managers and financial advisors shy away from day trading. They argue that, in most cases, the reward does not justify the risk. Moreover, many economists and financial practitioners argue that active trading strategies of any kind tend to underperform a more basic passive index strategy over time especially after fees and taxes are taken into account.
Profiting from day trading is possible, but the success rate is inherently lower because it is risky and requires considerable skill. And don’t underestimate the role that luck and good timing play. A stroke of bad luck can sink even the most experienced day trader.
Sufficient Capital
Wise day traders use only risk capital that they can afford to lose. This protects them from financial ruin and helps eliminate emotion from their trading decisions.
A large amount of capital is often necessary to capitalize effectively on intraday price movements, which can be in pennies or fractions of a cent.
Adequate cash is required for day traders who intend to use leverage in margin accounts. Volatile market swings can trigger big margin calls on short notice.
A trader needs to have an edge over the rest of the market. Day traders use any of a number of strategies, including swing trading, arbitrage, and trading news. They refine these strategies until they produce consistent profits and limit their losses.
There also are some basic rules of day trading that are wise to follow: Pick your trading choices wisely. Plan your entry and exit points in advance and stick to the plan. Identify patterns in the trading activities of your choices in advance.
There are two primary divisions of professional day traders: those who work alone, and/or those who work for a larger institution.
Most day traders who trade for a living work for large players like hedge funds and the proprietary trading desks of banks and financial institutions. These traders have an advantage because they have access to resources such as direct lines to counterparties, a trading desk, large amounts of capital and leverage, and expensive analytical software.
These traders are typically looking for easy profits from arbitrage opportunities and news events. Their resources allow them to capitalize on these less risky day trades before individual traders can react.
The Solo Day Traders
Individual traders often manage other people’s money or simply trade with their own. Few have access to a trading desk, but they often have strong ties to a brokerage due to the large amounts they spend on commissions and access to other resources.
However, the limited scope of these resources prevents them from competing directly with institutional day traders. Instead, they are forced to take more risks. Individual traders typically day trade using technical analysis and swing trades—combined with some leverage—to generate adequate profits on small price movements in highly liquid stocks.3
Day trading demands access to some of the most complex financial services and instruments in the marketplace. Day traders typically require all of the following:
Access to a Trading Desk
This is usually reserved for traders who work for larger institutions or those who manage large amounts of money.
The trading or dealing desk provides these traders with instantaneous order execution, which is crucial. For example, when an acquisition is announced, day traders looking at merger arbitrage can place their orders before the rest of the market is able to take advantage of the price differential.
Multiple News Sources
News provides most of the opportunities. It is imperative to be the first to know when something significant happens.
The typical trading room has access to all of the leading newswires, constant coverage from news organizations, and software that constantly scans news sources for important stories.
Analytical Software
Trading software is an expensive necessity for most day traders. Those who rely on technical indicators or swing trades rely more on software than on news. This software may be characterized by the following:
- Automatic pattern recognition: This trading program identifies technical indicators like flags and channels, or more complex indicators such as Elliott Wave patterns.
- Genetic and neural applications:These programs use neural networks and genetic algorithms to perfect trading systems and make more accurate predictions of future price movements.
- Broker integration: Some of these applications even interface directly with the brokerage, allowing for instantaneous and even automatic execution of trades. This eliminates emotion from trading and improves execution times.
- Backtesting: This allows traders to look at how a certain strategy would have performed in the past to predict more accurately how it will perform in the future. Keep in mind that past performance is not always indicative of future results.
Combined, these tools provide traders with an edge over the rest of the marketplace.
Risks of Day Trading
For the average investor, day trading can be a daunting proposition because of the number of risks involved. The U.S. Securities and Exchange Commission (SEC) highlights some of the risks of day trading, which are summarized below:
- Be prepared to suffer severe financial losses: Day traders typically suffer severe financial losses in their first months of trading, and many never make a profit.
- Day trading is an extremely stressful full-time job: Watching dozens of ticker quotes and price fluctuations to spot fleeting market trends demands great concentration.
- Day traders depend heavily on borrowing money: Day-trading strategies use the leverage of borrowed money to make profits. Many day traders not only lose all of their own money, they wind up in debt.
- Don’t believe claims of easy profits: Watch out for hot tips and expert advice from newsletters and websites catering to day traders and remember that educational seminars and classes about day trading may not be objective.