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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, taking advantage of small price moves – can be a lucrative game if played correctly. But it can be a dangerous game for those who are new to it or who don't adhere to a well-thought out method. Let's take a look at some general day trading principles and then move on to deciding when to buy and sell, common day trading strategies, basic charts and patterns, and how to limit losses. 

[ There are many different strategies that day traders use on a daily basis, ranging from fadings earnings reactions to scalping small profits. If you're interested in day trading, Investopedia's Become a Day Trader Course will show you everything that you need to know to get started. You'll learn proven strategies, risk management techniques, and much more from a Wall Street veteran in over five hours of on-demand video, exercises, and interactive content. ]

10 Basic Day Trading Tips

1) Knowledge is Power

In addition to knowledge of basic trading procedures, day traders need to keep up on the latest stock market news and events that affect stocks – the Fed's plans for interest rates, the economic outlook, etc. Do your homework. Make a wish list of stocks you'd like to trade and keep yourself informed about the selected companies and general markets. Scan business newspapers and visit reliable financial websites. 

2) Set an Amount Aside

Assess how much capital you're willing to risk on each trade. Most successful day traders risk less than 1%-2% of their account per 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 per trade is $200 (0.005 x $40,000). Set aside a surplus amount of funds that you can trade with and are prepared to lose (which may not happen).

3) Set Aside Time, Too

Day trading requires your time – most of your day, in fact. Don’t consider it 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 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 stay away from penny stocks. These stocks are 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, contributing to price volatility. A seasoned player may be able to recognize patterns and pick appropriately to make profits. But as a newbie, 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, and then movement begins to pick up again toward the closing bell. Though the rush hours offer opportunities, it’s safer for beginners to avoid them at first.

7) Cut Losses With Limit Orders

Decide what type of orders you will use to enter and exit trades. Will you use market orders or limit orders? When you place a market order, it is executed at the best price available at the time; thus, no “price guarantee.” 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 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.

 9) Stay Cool…

There are times when the stock markets test your nerves. As a day trader, you need to learn to keep greed, hope and fear at bay. Decisions should be governed by logic and not emotion.

10) And Stick to The Plan

Successful traders have to move fast, but they don't have to think fast. Why? Because they've developed a trading strategy in advance, along with the discipline to stick to that strategy. It is important to follow your formula closely rather than try to chase profits. There's a mantra among day traders: "Plan your trades, then trade your plan."

Now that you know some basic principles, let's move on the in and outs of day trading. 

Deciding What and When to Buy When Day Trading

Day traders seek to make money by exploiting minute price movements in individual assets (stocks, currencies, futures and options), usually leveraging large amounts of capital to do so. In deciding what to focus on – in a stock, say – a typical day trader looks for three things:

  • Liquidity: 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).
  • Volatility: Volatility is simply a measure of the expected daily price range — the range in which a day trader operates. More volatility means greater profit or loss.
  • Trading volume: This is a measure of how many times a stock is bought and sold in a given time period (most commonly, within a day of trading, which is known as the average daily trading volume). A high degree of volume indicates a lot of interest in a stock. Often, an increase in the volume in a stock is a harbinger of a price jump, either up or down.

Once you know what kinds of stocks (or other asset) you are looking for, you need to learn how to identify entry points – that is, at what precise moment you're going to invest. Tools that can help you do this include:

  • Real-time news services: News moves stocks, so it's important to subscribe to services to tell you when potentially market-moving news comes out.
  • ECN/Level 2 quotesECNs are computer-based systems that display the best available bid and ask quotes from multiple market participants, and then automatically match and execute orders. Level 2 is a subscription-based service that provides real-time access to the Nasdaq order book composed of price quotes from market makers registered in every Nasdaq-listed and OTC Bulletin Board securities. Together, they can give you a sense of orders being executed in real time.
  • Intraday candlestick charts: Candlesticks provide a raw analysis of price action (more on these later).

Define and write down the conditions under which you'll enter a position. "Buy during uptrend" isn't specific enough. "Buy when price breaks above the upper trendline of a triangle pattern, where the triangle was preceded by an uptrend (at least one higher swing high 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.

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 everyday) 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.

Deciding When to Sell

There are multiple ways to exit a wining position, including trailing stops and profit targets. Profit targets are the most common exit method, taking a profit at a pre-determined level. Some common price target strategies are:

Strategy Description
Scalping Scalping is one of the most popular strategies. It involves selling almost immediately after a trade becomes profitable. The price target is whatever figure that translates into "you've made money on this deal."
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.
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.

In most cases, you'll want to exit an asset when there is decreased interest in the stock as indicated by the Level 2/ECN and volume. The profit target should also allow for more profit to be made on winning trades than is lost on losing trades. If your stop loss is $0.05 away from your entry price, your target should be more than $0.05 away.

Define exactly how you will exit your trades before entering them. The exit criteria must be specific enough to be repeatable and testable.

Day Trading Charts and Patterns

To help determine the opportune moment to buy a stock (or whatever asset you're trading), many traders utilize:

  • Candlestick patterns, including engulfings and dojis
  • Technical analysis, including trendlines and triangles
  • Volume, increasing or decreasing

There are many candlestick setups a day trader can look for to find an entry point. 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, look for a pattern like this with several confirmations:

  • First, look for a volume spike, which will show you 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, look for prior support at this price level. For example, the prior low of day (LOD) or high of day (HOD).
  • Finally, look at the Level 2 situation, which will show all the open orders and order sizes.

If you follow these three steps, you can determine whether the doji is likely to produce an actual turnaround and can take a position if the conditions are favorable.

Traditional analysis of chart patterns also provides profit targets for exits. 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 profits at.

How to Limit Losses When Day Trading 

A stop loss order is designed to limit losses on a position in a security. 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 instance, 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.)

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 testable – and repeatable. Also, it is important to set a maximum loss per day that you can afford to withstand – both financially and mentally. Whenever you hit this point, take the rest of the day off. Stick to your plan and your perimeters. After all, tomorrow is another (trading) day.

Once you've defined how you enter trades and where you'll place a stop loss, you can assess whether the potential strategy fits within your risk limit. If the strategy exposes you too much risk, the strategy needs to altered in some way to reduce the risk. 

If the strategy is within your risk limit, 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, noting 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.

Finally, keep in mind that if trading on margin, which means that you are borrowing your investment funds from a brokerage firm (and bear in mind that margin requirements for day trading are high), you are far more vulnerable to sharp price movements. 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, is crucial when day trading on margin.

The Bottom Line

Day trading is difficult to master, requiring time, skill and discipline. Many of those who try it fail. But the techniques and guidelines 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.

 If you want to learn proven, profitable strategies you can start using today, from an experienced Wall Street trader, then check out Investopedia Academy's "Become a Day Trader" course.

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