Day traders will often work either independently or for professional financial institutions. While most trade stocks, they also work with other types of investments such as forex (i.e., currency), options contracts, cryptocurrency, etc.
How Does Day Trading Work?
Day trading is essentially the opposite of traditional investing. Conventional wisdom is that over the long term (ten or more years), markets will rise. For this reason, investors are encouraged to buy and hold assets so that they can ride out economic turbulence and short-term market fluctuations.
By contrast, day traders profit from these short-term price changes by purchasing securities during their low points and selling at their high points. According to FINRA (the Financial Industry Regulatory Authority), traders who make four or more day trades within five business days are considered to be day traders. These trades may take place within hours or even minutes of each other. Although the profits may be relatively small, the goal is that they will compound over time resulting in lucrative returns.
The way a day trader will do this is by using charts and sophisticated analysis. One of the most recognizable of these tools is candlestick charts which show the relative price movement of security as green or red “candlesticks” (meant to display gains and losses). Price changes can also be quantified using various metrics such as the MACD or RSI indicator.
Popular day trading strategies include:
- Swing trading
- Arbitrage
- Trading news
- Mergers / Acquisitions
Day traders will also often base their trades on recent market news or current events. For example, a forward earnings projection won’t appear in a historical price chart. However, it could certainly impact the company’s share price shortly after the announcement, and a day trader would look to exploit this opportunity.
Typically, a day trader will not hold security overnight. Because prices can fluctuate wildly between the previous day's close and the next day's opening, they won’t want to risk loss and will usually unload the security before the end of the day.
What are the Risks of Day Trading?
Day trading can be exciting and offer the possibility to make money quickly. However, given the nature of the activity, it can also be extremely risky with a high potential for financial losses, especially for those traders who are novices and inexperienced.
Generally, day traders will be faced with the following challenges:
Market Unpredictability
Despite a trader’s best efforts to quantify price movements and look for signals that indicate optimal trading opportunities, the market is still free to move as it pleases - especially when you consider outside factors such as economic developments, politics, wars, etc. No one can see into the future, and therefore there will always be the possibility that a security’s price moves in patterns that cannot be predicted based on historical pricing.
Emotional Bias
It’s easy for someone to say they will buy low and sell high. However, in execution, this can be difficult to do. The reason is that humans can be emotionally biased when it comes to investing. When someone buys a stock and it loses 25% of its value, their natural reaction may be to sell it before it goes down any further. However, to make a profit, they must be patient and await the moment when the market swings upward above their desired target.
High Stress
Because of market unpredictability and the potential for significant financial losses, day traders often experience high levels of stress. Additionally, many find they are constantly glued to their computer screens anxiously digesting the latest news feeds and looking for the next best trading opportunity.
Margin Losses
To maximize the amount of capital available, day traders will often rely on margin accounts. Trading on margin refers to essentially utilizing a line of credit from the brokerage. For example, a trader with an account of $10,000 may be given $5,000 worth of margin for a total of $15,000 available to trade. However, if the assets purchased drop in value too much, the brokerage may demand payment or possibly even liquify the investments. This would mean being forced to sell at a loss.
Taxes and Other Fees
In the U.S., short-term capital gains do not qualify for the lower tax rates that long-term capital gains enjoy (i.e., assets sold for a profit after being held longer than one year). Additionally, while many brokerages now offer 0% trading commissions, there are still other fees to consider such as:
- Regulatory fees (to the SEC)
- FINRA trading activity fees
- American depositary receipt fees
At the same time, some trading platforms offer premium accounts which give users access to more tools, charts, etc. Day traders need these tools and will often pay a monthly subscription to have them available.
Why is Day Trading So Popular?
With so much potential risk for financial loss and stress, some may wonder why so many people choose to engage in this activity.
Day trading can be traced as far back as the 1920s. Even before the use of computers, traders found that there was a potential to profit from intraday price discrepancies if orders could be executed quickly.
In recent times, day trading has had a resurgence due to the meme stock craze of 2021. This was a phenomenon when thousands of independent investors on the social media platform Reddit profited from the trading of shares of the American video game retailer GameStop and other popular companies. Many people claimed to profit from these trades - some even becoming millionaires within a short amount of time.
Also contributing to the interest in day trading is the fact that it's easier than ever to buy and sell stocks. Relatively new platforms such as Robinhood have streamlined the trading process making it beginner friendly. These same trading platforms have also done away with trading commissions meaning users can buy and sell as often as they’d like.
How to Get Started in Day Trading
For those who see day trading as a lucrative opportunity or even a potential career choice, certain steps should be taken to prepare.
- Understand market fundamentals. Just like any field, a professional has to know the environment in which they work. For traders, this means having a thorough understanding of how trading securities work, how the markets operate, and the strategies involved.
- Get trained in technical analysis. Because day trading strategies are so heavily reliant on chart analysis and metrics, it's crucial that investors understand these tools and know how to properly apply them.
- Use of analytical software. In conjunction with knowing how to perform technical analysis, day traders also need reliable software that they can use to demand these tools with the click of a button. This may be provided by the trading platform (either standard or for an additional fee) or be done through an independent software package.
- Investment funds. Trading takes money, and so investors need some seed capital to get started - especially when they are operating independently. It’s important that they limit how much they invest and don’t go beyond a figure they are comfortable losing if their trades don’t work as expected.
The Bottom Line
Day trading is the opposite of long-term investing and looks to exploit short-term market price changes to make money. Traders will use analytical tools and metrics to help them find the right times to buy and sell - usually during the day's open trading hours.
Day trading can be exciting and is theoretically an easy way to make a lot of money quickly. However, in reality, it can also be dangerous when done incorrectly or as the result of events outside the trader's control such as unpredictable swings in the market or political events. Therefore, day trading should only be performed after appropriate education has been attained and limits have been set on the amount of capital that will be invested.