What exactly is day trading? Who participates in the process? Can and should you get involved?
Day trading is defined as the buying and selling of a security within a single trading day. This can occur in any marketplace, but is most common in the foreign-exchange (forex) market and stock market. Typically, day traders are well-educated and well-funded. They utilize high amounts of leverage and short-term trading strategies to capitalize on small price movements in highly liquid stocks or currencies.
Day traders serve two critical functions in the marketplace: They keep the markets running efficiently via arbitrage, and they provide much of the markets' liquidity (especially in the stock market). This article will take an objective look at day trading, who does it and how it is done.
The profit potential of day trading is perhaps one of the most debated (and misunderstood) topics on Wall Street. Countless internet scams have capitalized on this confusion by promising enormous returns in a short period of time. Meanwhile, the media continues to promote this type of trading as a get-rich-quick scheme.
There are those who engage in this type of trading without sufficient knowledge; however, 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 that there is profit to be made. Still, they admit that the success rate is inherently lower as a result of the higher complexity and necessary risk of day trading, combined with all the related scams.
Day trading is not for everyone and involves significant risks. Moreover, it demands an in-depth understanding of how the markets work and various strategies for profiting in the short term.
What Is Day Trading?
Characteristics of a Day Trader
This article focuses on professional day traders – those who trade for a living, not simply as a hobby or for a "gambling high." These traders are typically well-established in the field and have in-depth knowledge of the marketplace. Here are some of the prerequisites to day trading:
Knowledge and Experience in the Marketplace: Individuals who attempt to day trade without an understanding of market fundamentals often end up losing money.
Sufficient Capital: One cannot expect to make money day trading. 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 that day traders utilize, 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.
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. The fact is, these people have access to things individual traders could only dream of, such as a direct line to a trading desk, large amounts of capital and leverage, expensive analytical software, and much more. These traders are typically the ones 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 can become important, especially when sharp price movements occur. For example, when an acquisition is announced, day traders looking at merger arbitrage can get their orders in before the rest of the market, taking advantage of the price differential.
Multiple News Sources: In the movie "Wall Street," Gordon Gekko says that "information is the most important commodity when trading." News provides the majority of opportunities day traders capitalize on, so it is imperative to be the first to know when something big happens. The typical trading room contains access to the Dow Jones Newswire, televisions showing CNBC and other news organizations, as well as software that constantly analyzes various other 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 typically contains many features, including:
- Automatic pattern recognition: This means that the trading program identifies technical indicators like flags and channels, or more complex indicators like Elliott Wave patterns.
- Genetic and neural applications: These are programs that utilize 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.
- Back testing: 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 (although 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.
The Bottom Line
Although day trading has become somewhat of a controversial phenomenon, its prevalence is undeniable. 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. If you find day trading interesting and would like to take a further step into researching the different brokers available, Investopedia has curated a list of the best stock brokers for day trading.