Day trading – the act of buying and selling a financial instrument within the same day, or even multiple times over the course of a day – can be a lucrative game. But it can also be a dangerous game for those who don't adhere to a well-thought out method. Still, since most brokerages allow for trading online, and it can be conducted from virtually anywhere, with only a few necessary tools and resources, there's nothing to bar an individual investor from trying his or her hand. Let's take a look at some common day trading strategies, as well as some general day trading tips, that can be used by retail traders.

Picking Assets to Trade

Day traders seek to make money by exploiting minute price movements in individual assets (usually stocks) or in indexes, usually leveraging large amounts of capital to do so. A typical day trader looks for three things in a stock: liquidity, volatility and trading volume.

  • Liquidity, in financial markets, refers to the relative ease with which a security is obtained, as well as the degree by which the price of the security is affected by its trading. Liquidity allows you to enter and exit a stock at a good price (i.e. tight spreads, or the difference between the bid and ask price of a stock, and low slippage, or the difference between the expected price of a trade and the actual price a stock trades at). Stocks that are more liquid are more easily day traded; moreover, liquid stocks tend to be more highly discounted than other stocks and are, therefore, cheaper. In addition, equity offered by corporations with higher market capitalizations are often more liquid than corporations with lower market caps, as it is easier to find buyers and sellers for the stock in question.
  • Stocks that exhibit more volatility lend themselves to day trading strategies, as well. Volatility is simply a measure of the expected daily price range – the time frame in which a day trader operates. More volatility means greater profit or loss. For example, a stock may be volatile if its issuing corporation experiences more variance in its cash flows. While markets will anticipate these changes for the most part, when extenuating circumstances transpire, day traders can capitalize on asset mispricing: Uncertainly in the marketplace creates an ideal day trading situation.
  • One handy indicator to help traders get a handle on a stock's liquidity and volatility is its volume. The volume of the stock traded is a measure of how many times it is bought and sold in a given time period (most commonly, within a day of trading, known as the average daily trading volume, or ADTV). More volume indicates interest in a stock, whether that interest is of a positive or negative nature. Oftentimes, an increase in the volume traded of a stock is indicative of price movement that is about to transpire. Day traders frequently use the Trade Volume Index (TVI) to determine whether or not to buy into a stock, which measures the amount of money flowing in and out of an asset.

Good Day Trading Sectors

Although these factors can apply to any sort of stock, certain industrial sectors lend themselves particularly well to day trading. They include:

Financial Services

Financial services corporations provide excellent day-trading stocks. Bank of America, for example, is a prime candidate for day trading – and in fact, is one of the most highly traded stocks per trading session – despite the banking system being viewed with increasing skepticism, as the industry has demonstrated systemic speculative activity, as in JP Morgan's $2 billion derivative gaffe back in 2012 (see JP Morgan: The Other Side Of The Hedge).

In addition, Bank of America's trading volume is high, making it a relatively liquid stock. For the same reasons, Wells Fargo, JP Morgan & Chase, Citigroup and Morgan Stanley make for very popular day trading stocks. All exhibit high trading volumes and uncertain industry conditions.

Social Media

The social media industry has also been an attractive target for day trading, recently. LinkedIn and Facebook both have a high trading volume for their stocks. Moreover, debate rages over the capability of these companies to transform their extensive user bases to a sustainable revenue stream. While stock prices theoretically represent the discounted cash flows of their issuing corporations, recent valuations also take into account the earnings potential of the companies. Thus, some analysts argue that this has resulted in higher stock valuations than the fundamentals suggest. Either way, social media continues to be a popular day trading stock group.

Money Management

Your first step in developing a strategy is assessing how much capital you're willing to risk on each trade. Most successful day traders risk less than one or two percent of their account on each trade.

If you have a $40,000 trading account, and are willing to risk 0.5% of your capital on each trade, your maximum loss on each trade is $200 (0.005 x $40,000). Knowing this amount will help determine if the entry points and exit points you establish in the next two steps are feasible for the amount of money you're willing to risk.

When To Buy

Once you know what kinds of stocks you are looking for, and how much you have to spend, you must develop pre-fixed levels in your mind for every stock you plan to trade. Knowing the price at which you wish to enter and exit an investment can help you book profits as well as save you from a wrong trade.

One of the best ways to do this is to use technical price patterns or chat patterns – recurring themes you see day in and day out, which more often than not lead to a certain defined outcome which you can capitalize on. Tools to identify these patterns include:

  • Intraday candlestick charts. Candles provide a raw analysis of price action.
  • Level II quotes/ECN. Level II and ECN provide a look at orders as they happen.
  • Real-time news service. News moves stocks; such services tell you when news comes out.

Looking at the intraday candlestick charts, we'll focus on these factors:

  • Candlestick patterns, including engulfings and dojis.
  • Technical analysis, including trend lines and triangles.
  • Volume, as in increasing or decreasing volume.

There are many candlestick setups that we can look for to find a potential buy. If properly used, the doji reversal pattern (highlighted in yellow in Figure 1) is one of the most reliable ones.

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Figure 1: Looking at candlesticks - the highlighted doji signals a reversal.

Typically, we will look for a pattern like this with several confirmations:

  • First, we look for a volume spike, which will show us whether traders are supporting the price at this level. Note that this can be either on the doji candle or on the candles immediately following it.
  • Second, we look for prior support at this price level. For example, the prior low of day (LOD) or high of day (HOD).
  • Finally, we look at the Level II situation, which will show us all the open orders and order sizes.

If we follow these three steps, we can determine whether the doji is likely to produce an actual turnaround and we can take a position if the conditions are favorable. (For more, see Forex Walkthrough: Chart Basics (Candlesticks).)

Entry Points

Entries – the point at which you buy a stock – only occur if the market produces a specific set of conditions which, more often not, produce a favorable result. You need to come up with your own criteria for entry rules, using tools like the charts above.

For example, first you look over a tick chart, 1-minute and 5-minute (or other times frames in between). Look for large or trending moves where there was a great profit potential. Was there a candlestick pattern which initiated the move? Could an indicator have signaled an entry point? Is there an overall trend (longer-term chart) which provided confirmation of the signal? Are chart patterns present, such as a triangle, flag, pennant, or head and shoulders pattern? These are questions to consider when assessing how to enter a position.

Specifically define and write down the conditions under which you'll enter a position. "Buy during uptrend" isn't specific enough. Instead you want something like: "Buy when price breaks above the upper trend line of a triangle pattern, where the triangle was preceded by an uptrend (at least one higher swing swing highs and higher swing low before the triangle formed) on the 2-minute chart in the first two hours of the trading day." This is much more specific and also testable (more on that later).

Also define whether you must wait for a price bar to complete to trigger an entry signal, or if you will take the signal in real-time when it occurs. In the triangle breakout example on the 2-minute chart, do you wait for the breakout bar to close above the triangle before entering, or do you enter as soon as the price crosses above the triangle trend line?

Once you've got a specific set of entry rules, scan through more charts to see if those conditions are generated each day (assuming you want to day trade every day) and more often than not produce a price move in the anticipated direction. If so, you have a potential entry point for a strategy. You'll then need to assess how to exit those trades.

Aiming at the (Price) Target

At a minimum, a strategy must have a way to exit both winning and losing trades. Identifying a price target – the point at which you want to sell an investment – will depend largely on your trading style. Here is a brief overview of some common day trading strategies:

Strategy Description
Scalping Scalping is one of the most popular strategies, which involves selling almost immediately after a trade becomes profitable. Here the price target is obviously just after you've made money.
Fading Fading involves shorting stocks after rapid moves upward. This is based on the assumption that (1) they are overbought, (2) early buyers are ready to begin taking profits and (3) existing buyers may be scared out. Although risky, this strategy can be extremely rewarding. Here the price target is when buyers begin stepping in again.
Daily Pivots This strategy involves profiting from a stock's daily volatility. This is done by attempting to buy at the low of the day and sell at the high of the day. Here the price target is simply at the next sign of a reversal, using the same patterns as above.
Momentum This strategy usually involves trading on news releases or finding strong trending moves supported by high volume. One type of momentum trader will buy on news releases and ride a trend until it exhibits signs of reversal. The other type will fade the price surge. Here the price target is when volume begins to decrease and bearish candles start appearing.

You can see that the entries in day trading strategies typically rely on the same tools used in normal trading; the main differences revolve around when the right time to exit is. In most cases, you'll want to get out when there is decreased interest in the stock as indicated by the Level II/ECN and volume. (For further reading, see Introduction To Types Of Trading: Momentum Trading and Introduction To Types Of Trading: Scalpers.)

Determining a Stop-Loss

Trading on margin means that you are borrowing money from a brokerage firm to trade. But to begin with, indulge in day trading without using margin. As a rookie, keeping control on the sums you play with is vital and trading with cash-in-hand helps to achieve that.

When you are ready to trade on margin (and bear in mind that margin requirements for day trading are high), you are far more vulnerable to sharp price movements than regular traders. Margins help to amplify the trading results – not just of profits, but of losses as well, if a trade goes against you. Therefore, using stop-losses, which are designed to limit losses on a position in a security, is crucial when day trading.

A stop loss order controls risk. For long positions a stop loss can be placed below a recent low, or for short positions above a recent high. It can also be based on volatility: For example, if a stock price is moving about $0.05 a minute, then you may place a stop loss $0.15 away from your entry in order to gives the price some space to fluctuate before it moves (hopefully) in your anticipated direction. Define exactly how you will control the risk on the trades. In the case of a triangle pattern, for example, a stop loss can be placed $0.02 below a recent swing low if buying a breakout, or $0.02 below the pattern. (The $0.02 is arbitrary; the point is simply to be specific.)

There are multiple ways to exit a winning position, including trailing stops and profit targets. Profit targets are the most common exit method – that is, taking a profit at a pre-determined level. Traditional analysis of chart patterns provides profit targets. For example, the height of a triangle at the widest part is added to the breakout point of the triangle (for an upside breakout) providing a price to take profit at. The profit target should allow for more profit to be made on winning trades than is lost on losing trades. If your stop loss is $0.05 way from your entry price, your target should be more than $0.05 away.

One strategy is to set two stop losses:

  1. A physical stop-loss order placed at a certain price level that suits your risk tolerance. Essentially, this is the most money you can stand to lose.
  2. A mental stop-loss set at the point where your entry criteria are violated. This means that if the trade makes an unexpected turn, you'll immediately exit your position.

However you decide to exit your trades, the exit criteria must be specific enough to be repeatable and testable.

Retail day traders usually also have another rule: Set a maximum loss per day that you can afford both financially and mentally to withstand. Whenever you hit this point, take the rest of the day off. Inexperienced traders often feel the need to make up losses before the day is over and end up taking unnecessary risks as a result. (To learn more, see The Stop-Loss Order–Make Sure You Use It.)

Test Your Trading Strategy

Once you've defined how you enter trades and where you'll place a stop loss, then testing begins. Manually go through historical charts finding your entries, noting whether your stop loss or target would have been hit. "Paper trade" in this way for at least 50 to 100 trades, note whether the strategy was profitable and if it meets your expectations. If so, proceed to trading the strategy in a demo account, in real-time. If it's profitable over the course of two months or more in a simulated environment, proceed with day trading the strategy with real capital. If the strategy isn't profitable, start over.

Find out which online broker is best for day traders here.

The Real World

While setting exit points and following strategy is important, traders aren't oblivious to external events. A top day trading scenario to take profits is right before a major economic or company-specific news release. This is done to protect profits. Day traders typically focus on capturing normal market movements throughout the day; a major economic news release, such the Non-Farm Payroll Report or an FOMC announcement, can cause sharp, massive price moves, which day traders are best to avoid. So, day traders are better off taking profits right before the news breaks, to avoid the risk of losing all their gains, and/or sustaining a large loss in the market's reaction. Once out, the trader can always look to re-enter the market based on the trend that develops in the aftermath of the announcement.

Day-Trading Tips: A Beginners' Checklist

Here are some more general principles for novices to keep in mind as they enter the day-trading realm.

1) Knowledge is Power

Not just knowledge about the basic trading procedures and strategies outlined above, but information about stocks you plan to trade (like company financials, reports and charts), knowing the latest stock market news, keeping track of events that affect stocks, etc. Do your homework; make a wish list of stocks, keep yourself informed about the selected companies and general markets, scan a business newspaper and visit reliable financial websites on a regular basis. An informed decision is a better decision.

2) Set a Amount Aside

Day trading is risky and there is a high chance of losses. Set aside a surplus amount of funds that you can trade with and are prepared to lose (which may not happen) while keeping money for your basic living, expenses, etc. This will ensure that you are not increasing the risk quotient by neglecting your day-to-day needs while day trading.

3) Set Aside Time, Too

Day trading requires your time – most of your day, in fact. Don’t consider it as an option if you have limited hours to spare. The process requires a trader to track the markets and spot opportunities, which can arise any time during the trading hours. Moving fast is key.

4) Start Small

As a beginner, it is advisable to focus on a maximum of one to two stocks during a day trading session. With just a few stocks, tracking and finding opportunities is easier.

5) Avoid Penny Stocks

Of course, you're looking for deals and low prices. But keep away from penny stocks. These stocks are highly illiquid and chances of hitting a jackpot are often bleak.

6) Time Those Trades

Many orders placed by investors and traders begin to execute as soon as the markets open in the morning, and thus contribute to price volatility. A seasoned player may be able to recognize patterns and pick appropriately to make profits. But as a novice, it is better to just read the market without making any moves for the first 15-20 minutes. The middle hours are usually less volatile while the movement begins to pick up towards the closing bell. Though the rush hours offer opportunities, it’s better for beginners to avoid that time to trade.

7) Limit Orders

Decide what type of orders you will use to enter and exit trades. Will you use market or limit orders? When you place a market order, it is executed at the best price available at the time of execution. Thus there is no “price guarantee” in a market order. A limit order, meanwhile, does guarantee the price, but not the execution. Limit orders help you trade with more precision wherein you set your price (not unrealistic but executable) for buying as well as selling.

8) Be Realistic About Profits

A strategy doesn't need to win all the time to be profitable. Many traders only win 50% to 60% of their trades. The point is, they make more on their winners than they lose on their losers. Make sure that the risk on each trade is limited to a specific percentage of the account, and that entry and exit methods are clearly defined and written down. The method should be so precise that even if you don't trade for a year you should be able to look at what you wrote down and know exactly what it means and what you have to do.

9) Stay Cool

There are times when the stock markets test your nerves. As a day trader you need to learn to keep confidence, greed, hope and fear at bay. The decisions should be governed by logic and not emotion – only someone who can learn to control his or her emotions can be successful. Before plunging into the real time arena, it can be a good idea to try a simulation exercise. (Investopedia has a stock simulator here.)

The Bottom Line

Day trading is a difficult skill to master, requiring as it does time, skill and discipline. Many of those who try it fail. But the techniques described above can help you create a profitable strategy and with enough practice and consistent performance evaluation, you can greatly improve your chances of beating the odds.

Variables such as the relative liquidity, volatility, trading volume and industry conditions are all contributing factors in determining what stocks are best for day trading. These are only guidelines, of course; as legendary trader Jesse Livermore once said, “I know from experience that nobody can give me a tip or a series of tips that will make more money for me than my own judgment.” Still, a sound understanding of some good day trading strategies provides a foundation for you to exercise that judgment.

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