There was a time years ago when the only people able to trade actively in the stock market were those working for large financial institutions, brokerages, and trading houses. However, over the past 25 years, developments such as the growth of discount brokerages and online trading, coupled with instantaneous dissemination of news worldwide and very low commissions, have leveled the playing—or should we say trading—field. In recent years, the popularity of trading platforms like Robinhood and zero commissions have made it easier than ever for retail investors to attempt to trade like the pros.

Day trading can turn out to be a lucrative career (as long as you do it properly). But it can also be a little challenging for novices—especially for those who aren’t fully prepared with a well-planned strategy. Even the most seasoned day traders can hit rough patches and experience losses.

So, what exactly is day trading, and how does it work?

Key Takeaways

  • Day traders are active traders who execute intraday strategies to profit from price changes for a given asset.
  • Day trading employs a wide variety of techniques and strategies to capitalize on perceived market inefficiencies.
  • Day trading is often characterized by technical analysis and requires a high degree of self-discipline and objectivity.

The Basics of Day Trading

Day trading usually refers to the practice of purchasing and selling a security within a single trading day. It can occur in any marketplace but is most common in the foreign exchange (forex) and stock markets. Day traders are typically well-educated and well-funded. They use high amounts of leverage and short-term trading strategies to capitalize on small price movements that occur in highly liquid stocks or currencies.

Day traders are attuned to events that cause short-term market moves. Trading based on the news is a popular technique. Scheduled announcements such as economic statistics, corporate earnings, or interest rates are subject to market expectations and market psychology. 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 attempts to make numerous small profits on small price changes throughout the day.
  • Range trading: This strategy primarily uses support and resistance levels to determine buy and sell decisions.
  • News-based trading: This strategy typically seizes trading opportunities from the heightened volatility around news events.
  • High-frequency trading (HFT): These strategies use sophisticated algorithms to exploit small or short-term market inefficiencies.

A Controversial Practice

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. Unfortunately, the idea that this kind of trading is some kind of get-rich-quick scheme persists. 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. Conversely, those who do day trade insist that there are profits to be made. Day trading profitably is possible, but the success rate is inherently lower because it is inherently risky and requires considerable skill. Moreover, economists and financial practitioners alike argue that, over long time periods, active trading strategies tend to underperform a more basic passive index strategy, especially after fees and taxes are taken into account.

Day trading is not for everyone and involves significant risks. Moreover, it requires an in-depth understanding of how the markets work and various strategies for profiting in the short term. While the success stories of those who struck it rich as a day trader often get a lot of media attention, remember that this is not the case for most day traders: Many will fizzle out, and many will just barely stay afloat. Furthermore, don’t underestimate the role that luck and good timing play—while skill is certainly an element, a stroke of bad luck can sink even the most experienced day trader.

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What Is Day Trading?

Characteristics of a Day Trader

Professional day traders—those who trade for a living rather than as a hobby—are typically well-established in the field. They usually have in-depth knowledge of the marketplace, too. Here are some of the prerequisites required to be a successful day trader.

Knowledge and Experience in the Marketplace

Individuals who attempt to day trade without an understanding of market fundamentals often lose money. Technical analysis and chart reading are both good skills for a day trader to have. But without a more in-depth understanding of the market that you’re in and the unique risks that exist in that market, charts may be deceiving. Do your due diligence and understand the particular ins and outs of the products that you trade.

Sufficient Capital

Day traders use only risk capital that they can afford to lose. This not only protects them from financial ruin but also helps eliminate emotion from their trading. A large amount of capital is often necessary to capitalize effectively on intraday price movements. Having access to adequate capital is very important, since most day trading employs a high degree of leverage in margin accounts, and volatile market swings can trigger big margin calls on short notice.

Strategy

A trader needs an edge over the rest of the market. Several different strategies are used by day traders, including swing trading, arbitrage, and trading news. These strategies are refined until they produce consistent profits and effectively limit losses.

Strategy Breakdown
Type Risk Reward
Swing Trading High High
Arbitrage Low Medium
Trading News Medium Medium
Mergers/Acquisitions Medium High

Discipline

A profitable strategy is useless without discipline. Many day traders end up losing a lot of money because they fail to make trades that meet their own criteria. As the saying goes, “Plan the trade and trade the plan.” Success is impossible without discipline.

To profit, day traders rely heavily on volatility in the market. A stock may be attractive to a day trader if it moves a lot during the day. That could happen because of a number of different things, including an earnings report, investor sentiment, or even general economic or company news.

Day traders also like stocks that are very liquid because that gives them the chance to change their position without altering the price of the stock. If a stock price moves higher, traders may take a buy position. If the price moves down, a trader may decide to short sell so they can profit when it falls.

Regardless of what technique a day trader uses, they’re usually looking to trade a stock that moves (a lot).

Day Trading for a Living

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 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 (among other advantages). These traders are typically looking for easy profits that can be made from arbitrage opportunities and news events; these resources allow them to capitalize on these less risky day trades before individual traders can react.

Individual traders often manage other people’s money or simply trade with their own. Few of them have access to a trading desk, but they often have strong ties to a brokerage (due to the large amounts that 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 such small price movements in highly liquid stocks.

Day trading demands access to some of the most complex financial services and instruments in the marketplace. Day traders typically require:

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 executions, which are particularly important when sharp price movements occur. 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 the majority of opportunities from which day traders capitalize, so it is imperative to be the first to know when something significant happens. The typical trading room has access to the multiple leading newswires, constant coverage from news organizations, and software that constantly analyzes 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 means that the trading program identifies technical indicators like flags and channels, or more complex indicators such as Elliott Wave patterns.
  • Genetic and neural applications: These are programs that use neural networks and genetic algorithms to perfect trading systems to make more accurate predictions of future price movements.
  • Broker integration: Some of these applications even interface directly with the brokerage, which allows for an instantaneous and even automatic execution of trades. This is helpful for eliminating emotion from trading and improving 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. It is easy to see why, without them, so many inexperienced traders lose money. Additionally, other elements that influence a day trader’s earnings potential are the market in which they trade, how much capital they have, and the time they are willing to devote.

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: As day traders typically suffer severe financial losses in their first months of trading, and many of them never graduate to making profits, they should only risk money that they can afford to lose.
  • Day trading is an extremely stressful and expensive full-time job: Day trading is extremely difficult and demands great concentration to watch dozens of ticker quotes and price fluctuations to spot market trends. Day traders also incur high expenses, typically paying their firms large amounts for commissions, training, and computers.
  • Day traders depend heavily on borrowing money: Day-trading strategies use the leverage of borrowed money to make profits, which is why many day traders not only lose all of their money but also end 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.

Should You Start Day Trading?

As mentioned above, day trading as a career can be very difficult and quite challenging.

  • First, you need to come in with some knowledge of the trading world and have a good idea of your risk tolerance, capital, and goals.
  • Day trading is also a career that requires a lot of time. If you want to perfect your strategies—after you’ve practiced, of course—and make money, then you’ll have to devote a lot of time to it. This isn’t something that you can do part time or whenever you get the urge. You have to be fully invested in it.
  • If you do decide that the thrill of trading is right for you, remember to start small. Focus on a few stocks rather than going into the market headfirst and wearing yourself thin. Going all out will only complicate your trading strategy and can mean big losses.
  • Finally, stay cool and try to keep the emotion out of your trades. The more you can do that, the more you’ll be able to stick to your plan. Keeping a level head allows you to maintain your focus while keeping you on the path you’ve selected to go down.

If you follow these simple guidelines, it’s possible that you may be headed for a sustainable career in day trading.

Is day trading illegal?

While day trading is not illegal or unethical, it can very risky. Since most day-trading strategies employ leverage in margin accounts, day traders can potentially lose more than they have invested and end up with significant debt.

How can arbitrage be employed as a day-trading strategy?

Arbitrage is the simultaneous purchase and sale of the same security in different markets to profit from minute differences in the security’s price in these markets. As arbitrage provides a mechanism to ensure that any deviation in the price of an asset from its fair value gets corrected rapidly, arbitrage opportunities seldom last long.

Why don’t day traders hold positions overnight?

Day traders typically do not hold positions overnight for a number of reasons: Most brokers have higher margin requirements for overnight trades, and therefore additional capital is required; a stock can gap down or up on overnight news, inflicting a big trading loss; and holding a loss-making position overnight in the hope that part or all of the losses can be recouped may violate the trader’s core day-trading philosophy.

What are the margin requirements for day traders?

According to Financial Industry Regulatory Authority (FINRA) rules, the minimum equity requirement for a client of a broker-dealer who is designated as a pattern day trader is $25,000, which must be deposited into the client’s account prior to any day-trading activities and maintained at all times.

What is day trading’s buying power?

Buying power refers to the total funds that an investor has available to trade securities, and it equals cash held in the account plus available margin. According to FINRA rules, a broker-dealer client who is designated as a pattern day trader may trade up to four times their maintenance margin excess as of the previous day’s close of business for equities.

The Bottom Line

Although day trading has become somewhat controversial, it can be a viable way to earn a profit. Day traders, both institutional and individual, play an important role in the marketplace by keeping the markets efficient and liquid. While day trading remains popular among inexperienced traders, it should be left primarily to those with the skills and resources needed to succeed.

Article Sources

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  1. U.S. Securities and Exchange Commission. “Day Trading: Your Dollars at Risk.” Accessed Jan. 17, 2022.

  2. U.S. Securities and Exchange Commission. “Margin Rules for Day Trading.” Accessed Jan. 17, 2022.