Day trading is one of the most debated and, at times, misunderstood, topics for investors to understand. There are too many stories of investors who have lost a significant amount of money, if not their whole investment portfolio with the belief that they could get rich from day trading.
However, for all of these stories, there are other investors who are quite successful as either a part-time or full-time day trader. Many professional financial advisors and investment managers would reject day trading as not being worth the risk. And even the most successful day traders admit that there is a high probability of losing money in day trading.
In a nutshell, day trading is not for every trader. And there are significant risks. This article attempts to explain what day trading is, what day traders trade, how day trading can benefit the market, characteristics of successful day traders, and some things to look for when selecting which assets to trade and how to effectively use stop-loss orders to get out of trades.
What is day trading?
Day trading is the practice of buying and selling securities within a single day. Although day traders will frequently enter and exit trades within several hours, or even several minutes, the recognized classification of a day trader is someone who enters and closes a position within the same day. Two distinguishing characteristics of day trading are the use of leverage (i.e. borrowed money) and the application of short-term trading strategies to profit from small price changes in highly liquid stocks or currencies.
What do day traders trade?
There is almost no limit to what a day trader can trade, but the most common assets traded in day trading are the forex (foreign exchange) market and the stock market. Many experienced day traders may also venture into more markets such as commodities. But because of their inherent volatility, commodities usually fall outside of the average day trader's risk tolerance.
Are there any benefits to day trading beyond personal profit?
Although day trading is commonly thought of in terms of individual investors working from home, the majority of day traders work for institutional investment firms. In this context, day trading provides two important functions for the markets. First, they create efficiency through the process of arbitrage and because day trading is characterized by entering and exiting trades quickly, they provide a majority of the liquidity, particularly in the stock market.
What are the qualities of a successful day trader?
Day trading is shrouded in controversy but is frequently misunderstood. Part of the reason for this is the prevalence of day trading scams that promise instant and limitless riches to novice investors even with a minimal trading account. But day trading is not for novice investors. Two essential characteristics that day traders must possess are a detailed knowledge of how markets move as well as proficiency in technical analysis. But equally important is a trading account that is sufficiently funded to ensure that they are truly trading capital that they are willing to put at risk and, just as importantly, can afford to lose.
This second point, having an amply funded trading account, is critical to understanding day trading. Most day traders make the mistake of not taking the time to learn and practice different day trading strategies before putting their capital at risk. Some of these day traders are simply gamblers who like the rush of day trading. But, like many gamblers, they lack the discipline needed for day trading. This brings to light another essential characteristic that day traders must possess, the ability to make a plan and stick to it. This is necessary to keep them from financial ruin and helps take the emotion out of trading.
In addition to the mental and emotional characteristics that all day traders should possess, there are a few other things that day traders require.
- Trading Desk Access: This is not possible for the day trader who works from their home, but day traders who work for large institutions are typically given direct access to the trading desk. This allows instantaneous execution of their trades. This is very important because of their need to react to sharp price movements.
- Multiple Reliable News Sources: In day trading, access to information is essential. You’ll often hear the phrase “Trading the News” attributed to day traders. This is because day traders rely on sharp price movements and that typically occurs when some event occurs outside of the market that causes investors to buy or sell in a volume that affects the asset’s price.
- Trading Software: This can be expensive for the day trader that works from home. However, because day trading is so reliant on technical analysis, they rely on software to help them recognize patterns, to have access to the networks and algorithms that help them make accurate predictions of future price movements, integration with a broker for automatic, instant execution of trades, and the ability to perform backtesting a process by which traders can see how a strategy has performed in the past as a predictive measure of future performance.
- If you're day trading from home, you should also plan on having one or more reliable computers. This is because you may want to have the ability to view multiple screens. In this day and age, a high-speed internet connection is almost a given, but nevertheless, you should be sure to have one and you'll also want to ensure you have a reliable phone to contact your broker in case you have a problem with the internet.
How much money do you need to begin day trading?
The short answer is that day trading requires a large amount of capital in order to effectively take advantage of intraday price movements. The specific answer depends on what is being traded.
Legally, an investor must have a trading account valued at $25,000 to begin day trading stocks. Realistically, however, since day traders are required to keep their account funded with a minimum of $25,000, day traders should look to have at least $30,000 in their account.
This is where day trading can get exciting, and complicated. The stock market allows day trades to utilize up to 4:1 leverage for their accounts. This simply means that a $30,000 trading account can actually give day traders up to $120,000 to invest.
Investors who are looking to trade in the forex market can open an account for as little as $500 (although once again, more is recommended). In forex trading, investors can use up to 50:1 leverage. While most investors would never need to use that much leverage, it’s not uncommon for these investors to use 5:1 or even 10:1 leverage to help facilitate their trades.
Investors can day trade futures with as little as $1,000 with varying amounts of leverage and minimum requirements depending on the asset being traded.
What to look for when entering a trade?
There are, literally, thousands of stocks that can be day traded. When you add in the forex or futures markets, that number can easily reach the tens of thousands. Which assets are traded really depends on the individual day trader. But there are three characteristics that all day traders should look for:
- Volume - day trading requires a high stock volume or at least a volume that makes it possible to enter and exit trades on demand and without the slippage that can occur when a trader wants to exit a trade (more on that below). In general, day traders look for stocks that have a daily volume of at least 1,000,000. Many trading programs include a stock screener that can help a day trader quickly narrow down a list of stocks to a manageable list by sorting them based on volume.
- Volatility – day trading relies on strong movement in order to generate profits. No two stocks are exactly alike. Some stocks may move 0.5% on a trading day, while others may move 1% or even as high as 5%. Although there is no rule for choosing a stock based on volatility, most day traders prefer to find stocks that move within a range of 0.5% - 2%. The more volatile the stock, the faster traders have to be in executing their trades.
- Look for Trends or Ranges – Most day traders look for specific trends or ranges to decide which stocks to trade. Some traders only like to trade on ranges. Others only trade on trends. But there are some who trade both effectively.
What strategies should day traders use to execute a trade?
All day traders, particularly those that are just starting to trade, should become very familiar with stop loss orders. Stop loss orders are an ideal way to take the emotion out of trading. Earlier we said that it was essential for day traders to be able to make a plan and execute that plan. Stop loss orders are an easy way to do this.
However, there are different types of stop loss orders. To be successful, day traders need to know what the differences are and how/when to use them. For the purposes of this article, we’ll focus on two types of orders: market orders and limit orders. Either one can be used for buying or selling. What follows is an explanation of the two types.
- Stop Loss Market Orders – these orders are placed at a specific price. Once you place a market order and the market price reaches the order price, the order becomes “live” and the order will be executed at the price you are requesting or whatever price is available in the marketplace. The second part of this sentence is critical to understanding this type of order. An example will illustrate this better. Let's say a trader buys a certain stock at $25 and places a stop loss market order at $24.90. A major news announcement causes buyers to get jittery and they pull all their bids for a stock at $25. This creates a scenario where nobody is willing to buy except at $24.70, $0.20 below your stop loss point. So instead of losing $0.10 on the trade, the investor lost $0.30. This event, known as slippage, occurs because market orders are always filled at the best available price, not necessarily at the price specified. When a particular stock or asset is trading quickly, a stop loss market order may be executed at a much worse price than expected. They are used when a trader definitely wants to exit a position quickly.
It’s important to understand that under normal market conditions, trades do not generally experience slippage. One way to help minimize slippage is to trade assets with high volume.
- Stop Loss Limit Orders – The simplest way to understand a limit order is that the trade will only be executed at the exact price a trader specifies. As you can guess, this can create a situation where a trade is simply not executed or may be delayed for a long time. In our example above, if high volatility plunged a stock past a trader's stop-loss limit price of $24.90 down to $24.70. The trader will have to wait until when and if the stock climbs back to exactly $24.9 for the trade to be executed.
This brings to mind the critical distinction between a market order and a limit order. A market order will always be executed, but perhaps not for the exact price being specified. A limit order may not always be executed, but when it is executed it will always be for the exact price specified.
The bottom line on day trading
Day trading is an often misunderstood investment technique. While it gets a bad reputation from scammers who prey on the naiveté of novice investors who lack the knowledge and discipline that is required for day trading, there are many day traders that can profit from this type of trading.
One of the essential requirements for any day trader is an account that is adequately funded. In the case of stocks, that means an account with a value of at least $25,000; for forex trading day traders can open an account for just $500; futures accounts can be started for a minimum of $1,000. Because day trading allows the use of leverage, day traders are able to borrow money from a brokerage to give them access to higher volume trading.
With so many potential stocks to choose from, it's important to find stocks that meet the basic criteria of volume, volatility, and stocks that show a trend or range pattern that provide guidance to future performance. And everyday trader, particularly the novice trader, should apply stop loss orders to every trade in the form of a market order for a trade that they definitely want to exit or a limit order where the price takes precedence over the actual execution of the trade.