There was a time when the only people who were able to trade were those working for large financial institutions, brokerages and trading houses. But with the rise of the internet, online trading houses and brokers have made it easier for the average, individual investor to get in on the game.

Day trading can be a very lucrative career, as long as you do it properly. But it can be a little challenging for novices — especially for those who aren't fully prepared with a well-planned strategy. But what exactly is day trading and how does it work?

This short article looks at the basics of day trading. Read on to find out more.

The Basics of Day Trading

Day trading is defined as the purchase and sale of 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 in highly liquid stocks or currencies.

The Controversy

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. The idea that this kind of trading is a 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 arguing 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 because of the complexity and necessary risk of day trading in conjunction with the related scams.

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. 

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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.

Sufficient capital: 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.

A strategy: 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.

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 they say, "Plan the trade and trade the plan." Success is impossible without discipline.

How it Works

In order 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 he 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, expensive analytical software, and much more. These traders are typically looking for easy profits that can be made from arbitrage opportunities and news events, and 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 require:

Access to the 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 is 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 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 of CNBC and other 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 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.

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 you should 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, 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 profit. Day traders, both institutional and individual, play an important role in the marketplace by keeping the markets efficient and liquid. While popular among inexperienced traders, it should be left primarily to those with the skills and resources needed to succeed.