The term day trading often evokes images from the movie “Wall Street” or, more recently, “The Wolf of Wall Street,” with traders frantically moving in and out of stocks and making copious amounts of money. In reality, most day traders trade from their home or office with the help of a fast Internet connection, computer algorithms, and an eye for reading price and volume charts for predictable patterns.
The Financial Industry Regulation Authority (“FINRA”) and U.S. Securities and Exchange Commission (“SEC”) define day traders as traders that buy and sell a particular security in the same trading day four or more times in any consecutive five business day period. These pattern day traders are required to maintain an equity balance of at least $25,000 if they are buying stock on margin.
Be sure to see the 25 Stocks Day Traders Love
Purpose and Evolution
Day traders provide liquidity in the financial markets and ensure that a stock is fairly valued by buying and selling shares throughout the day based on market inefficiencies or historical price patterns.
For example, day traders using arbitrage strategies will profit from the difference in price between an American Depository Receipt (“ADR”) and foreign stock until there’s virtually no price difference left minus the risk premium. As a result, long-term investors know that their ADRs will track foreign stock prices and will be able to buy and sell ADRs easily within the open market.
Due to fixed commissions and long settlement periods, day trading didn’t become widely popular until electronic trading took over in the 1990s. Purchasing stock with low commission rates, very little slippage, and in just seconds, electronically opened up new doors to individual traders looking to capitalize on various market efficiencies and generate consistent profits from any Internet connection.
Day Trading Strategies
Day trading takes many different forms given the many different ways to profit from the movement of security prices, but in the end, all day traders capitalize on market inefficiencies or historical tendencies.
Event-driven day traders may buy and sell securities that experience event-driven movements, such as negative earnings releases, new product releases, or other market moving news. Often, the volatility provided by these events creates the potential to profit, while the emotional nature of many investors makes the market somewhat inefficient – two key ingredients to generating profits.
High frequency trading and other types of automated trading have become very popular among day traders, since the systems take emotion out of the equation and generate more predictable returns. These traders develop computer programs that rapidly buy and sell securities based on price, volume, or technical data points with fast Internet connections nearby major equity or futures exchanges.
Technical day traders use technical analysis techniques, like trend following indicators, to buy and sell stocks at a profit between major fundamental news events.
Contrarian day traders attempt to pick tops and bottom using other technical indicators and profit from a change in trends. And, range day traders attempt to buy and sell at well defined price extremes.
Finally, electronic communication networks (“ECNs”) charge commissions to customers that want their orders filled immediately at the best available price, while paying commissions to buyers and sellers that add liquidity by placing limit orders that make a market in a security. Rebate trading aims to profit from contributing that liquidity over time by collecting liquidity commissions.
Most day traders tend to focus on large and liquid markets in order to minimize transaction costs, although some traders prefer to generate profits from adding liquidity in low-priced markets, as is the case with rebate trading.
Blue chip stocks, like Apple Inc. (NASDAQ: AAPL) or Google Inc. (NASDAQ: GOOG), have become very popular among day traders given the high level of liquidity and event-driven volatility. For example, many day trades compile lists of major companies announcing earnings and then attempt to buy and sell throughout the day to capitalize on the inevitable price volatility.
Index futures, like the S&P 500 Index (NYSE: SPY), have become very popular as broader economic bets for day traders given their high level of liquidity and less stock-specific risk. For example, many day traders are focused on trading e-minis with a focus on either economic event-driven moves&8212;such as GDP releases or FOMC minutes&8212;or purely technical trading using chart setups or indicators.
Risks & Rewards
Day trading can be a very rewarding career to those who have an interest in the equity and futures markets, but there are many risks that traders should carefully consider, especially given the low success rate.
Day trading risks include:
- Difficulty. A 2003 article published in the Financial Analysts Journal found that “about twice as many day traders lose money as make money”, while only 20% of sample day traders were “more than marginally profitable”.
- Leverage. Day traders often employ leverage in order to amplify potential gains, but leverage is a double-edged sword that can also amplify losses, particularly when used in excess without adequate capitalization.
- Evolution. Day trading is highly competitive, constantly evolving, and requires a frequent change in strategy to remain successful, which means that traders need to be constantly improving themselves.
Day trading benefits include:
- Freedom. Day traders are sometimes able to work from home and generate enough money to make a comfortable living, while the most successful day traders can consistently make large amounts of money.
- Fun. Day trading can be a very rewarding activity given the fast-paced and constantly evolving nature of the business; however, the emotional rollercoaster ride means that traders need to have the right mindset.
- Compounding. Day trading strategies can often be scaled quite easily to accommodate larger trade sizes, which means that traders can leverage their past returns to make consistently larger amounts of money over time.
As a general rule, day traders should be proficient at paper trading (e.g. trading with imaginary capital) before committing real capital, as well as have a sufficient level of risk capital that they can afford to lose before trading.
The Bottom Line
Day traders attempt to profit from market inefficiencies and historical tendencies using many different strategies, ranging from simple technical analysis to rebate commissions from ECNs for providing liquidity. Day trading benefits the rest of the market in the form of enhanced liquidity (e.g. lower spreads) and efficiency, but the market remains very competitive and risky for individuals.
While twice as many day traders lose money as make money, the career can be very rewarding for those who put in the time and money to learn. Traders can reduce risk by ensuring they are adequately capitalized, investing in the right education, and trying out their strategies with paper trading before real trading. As in any other career, the best prepared candidates are often the most successful.
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