There was once a time when the only people who were able to trade actively in the stock market were those working for large financial institutions, brokerages, and trading houses. However, with the rise of the internet and online trading houses, it's become easier for the average individual investor to get in on the game.
Day trading can turn out to be a very 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?
- Day traders are active traders who execute intraday strategies to profit off of 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. While it can occur in any marketplace, it 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 prices 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 perhaps one of the most debated and misunderstood topics 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 there is profit to be made. Day trading profitably is possible, but the success rate is inherently lower. This is because of the complexity and necessary risk of day trading in conjunction with the related scams. 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 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.
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 you're in and the assets that exist in that market, charts may be deceiving. Do your due diligence and understand the particular ins and outs of the products you trade.
Day traders use only risk capital which they can afford to lose. Not only does this protect them from financial ruin, but it 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 a margin account is also key since volatile swings can incur margin calls on short notice.
A trader needs an edge over the rest of the market. There are several different strategies day traders use including swing trading, arbitrage, and trading news. These strategies are refined until they produce consistent profits and effectively limit losses.
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 they say, "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 heavily 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 a large institution. These traders have an advantage because they have access to a direct line, 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 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 working for larger institutions or those who manage large amounts of money. The 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 contains access to the Dow Jones Newswire, constant coverage from news organizations, and software that constantly analyzes news sources for important stories.
Trading software is an expensive necessity for most day traders. Those who rely on technical indicators or swing trades rely more on software than news. This software may be characterized by the following:
- Automatic pattern recognition: This means 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 in order 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 they trade in, how much capital they have, and the time they are willing to devote.
Should You Start Day Trading?
As mentioned above, day trading as a career can be very difficult and quite a challenge. 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, you'll have to devote a lot of time to it. This isn't something 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 head-first 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 you may be headed for a good career in day trading.
The Bottom Line
Although day trading has become somewhat of a controversial phenomenon, 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.