During the heyday of the tech bubble in the late 1990s, day traders made easy money buying and selling internet stocks. It didn't take much skill to succeed in those days. In just a 17-month period between October 1998 and March 2000, the Nasdaq Composite skyrocketed from roughly 1,344 to a high of around 5,132. All you had to do was ride that tidal wave to rake in the profits. Many of those traders made just as much shorting the index on its way down to a low of about 1,108 in October 2002, losing 78% of its value in 31 months.
Once the bubble fully deflated, the easy money dried up. Many of those who profited through good luck and timing left trading and looked for other work. They discovered that day trading, like any other profession, requires education and skills to consistently make a living.
But how does one become a day trader? Read on to find out some of the key requirements and characteristics of a day trader.
What Defines a Day Trader?
As of Sept 28, 2001, FINRA and NYSE amended their definitions of day traders. A new term they use is "pattern day trader." An investor can be classified as a pattern day trader by having one of the two following characteristics:
- He or she trades four or more times during a five-day span, provided the number of day trades is more than 6% of the customer's total trading activity for that same five-day period, or
- The firm where the investor is making transactions, or opening up a new account, reasonably considers him or her a day trader.
Once an investor is considered a day trader, the brokerage must classify him or her as such, and the investor is then subject to increased equity requirements. Mainly, the brokerage must require a minimum equity of $25,000 at the beginning of the customer's trading day. This minimum equity requirement has been introduced by the Securities & Exchange Commission (SEC) and the NYSE. Ensuring that any substantial losses can be offset by the day trader's own equity, the requirement addresses the inherent risk imposed on brokerages by leveraged day trading activities.
A more restrictive margin rule has also been implemented. Day traders are permitted to purchase only four times their maintenance margin levels. If this level is exceeded, the firm must issue a margin call to the day trader who subsequently has five business days to deposit the funds before the account is restricted to trading on a cash-available only basis for 90 days or until the call is met.
How To Become A Day Trader
A Tale of Two Traders
There are two different kinds of day traders. Professional day traders work for large financial institutions. They have access to the tools and training needed to make their careers a success. The big advantage of being a professional day trader is that you aren't trading their own capital. Instead, it is capital from clients and/or the firm, so there's no personal risk. Most professional traders are able to leave their emotions and biases at the door.
The other kind of day trader is the individual trader, who play the markets solo. These traders need to be able to understand the market, technical analysis, and price movements. They should also have access to research, news, and analysis. And unless they have clients for whom they trade, they're usually trading their own capital, which means there's a lot at stake.
On the subject of capital, individual traders usually have a couple of options when it comes to their trading accounts. The first option is a cash account, from which traders can make their trades after depositing their own capital. The second option is a margin account. This is basically a loan from the brokerage. Most firms will require a minimum investment before traders can begin trading on margin. Since they're dealing with money from a firm, there are usually more rules to follow.
Day Trading Basics
Day trading requires a professional software platform and a high-speed internet connection. While it's possible to design and build your own trading platform, most traders use a prepackaged setup provided by their brokerage or a specialized software company. It's best to have a powerful desktop with at least two monitors — preferably four to six. You need multiple screens to display the charts and technical indicators that will provide your buy and sell signals.
When you use a brokerage platform, ensure that real-time news and data feeds are included in the package. You'll need that data to construct charts that expose trends and portray the time frames and trading strategies you want.
A pure day trader buys and sells stocks or other investments and ends the trading day in cash with no open positions. If a position is held overnight or for several days, it's called a swing trade. Most day traders use both approaches, depending on their trading style and the nature of their investments.
Familiarity with stocks and market fundamentals isn't enough to succeed as a trader. You should understand technical analysis and all of the tools used to dissect chart patterns, trading volume and price movements. Some of the more common indicators are resistance and support levels, moving average convergence divergence (MACD), volatility, price oscillators, and Bollinger Bands.
Learning and understanding how these indicators work only scratches the surface of what you'll need to know to develop your personal trading style. Hundreds of books and thousands of articles have been written about day trading. You can also take classes online or in person.
Day Trading Strategies
Trading requires sufficient capital to take advantage of leveraging fairly large positions. Most traders make their money on relatively small price movements in liquid stocks or indexes with mid to high volatility. You need price movement to make money — either long or short. Higher volatility implies higher risk, with the potential for greater rewards and losses.
Unless you can buy several hundred or more shares of a stock, you won't make enough money on trades to cover the commissions. The lower the price of the stock, the more shares you'll need to gain sufficient leverage and total price movement.
The key to successful trading is developing techniques to determine entry and exit points. Most traders develop a style they stick with once they are comfortable with it. Some only trade one or two stocks every day, while others trade a small basket of favorites. The advantage of trading only a few stocks is that you learn how they act under different conditions and how movement is affected by the key market makers.
Develop a process and try it out with fictional trades. Refine the process and find what works for you. Only then should you put real money on the line and start actively trading the markets. Experienced traders define what constitutes a trading setup, and the pattern and indicator combination they want to see before pulling the trigger. They rarely deviate from those setups in order to maintain focus and keep their emotions at bay.
Once you enter a position, stops should be placed to get you out of that position when a specified loss threshold is reached. If a trade is going the wrong way, hope will not help turn it around. Exiting the trade frees up your capital to redeploy to a more promising trade. You want to exit losers as soon as possible and ride the winners as long as they're profitable.
Day Trading Success
The success rate for day traders is estimated to be around only 10%. While all the attention day trading attracts, it seems to suggest the theory is sound. Critics argue that, if that were so, at least one famous money manager would have mastered the system and claimed the title of "the Warren Buffett of day trading."
The long list of successful investors that have become legends in their own time does not include a single individual that built his or her reputation by day trading. Even Michael Steinhardt, who made his fortune trading in time horizons ranging from 30 minutes to 30 days, claimed to take a long-term perspective on his investment decisions. From an economic perspective, many professional money managers and financial advisors shy away from day trading, arguing that the reward simply does not justify the risk.
So, if around 90% of day traders are losing money, how could anyone expect to make a living this way? The answer lies in professional training, diligent research, refined skills, great discipline and the ability to admit mistakes and cut your losses. You have to be prepared to make split-second, unemotional decisions based on information that is sometimes incomplete, contradictory and changing by the second. The statistics prove it's clearly much easier said than done.
The Bottom Line
Day trading is not for the faint of heart. A winning strategy may involve executing many trades in one day while avoiding the trap of overtrading and running up huge commissions. Day trading can be fun as well as profitable — if you learn the ropes and set realistic goals. If you are interested in becoming a day trader your first step should be to choose a broker that fits your needs.