Day trading has become a hot topic lately. In early 2021, members of the WallStreetBets group on Reddit showed just how powerful retail day traders can be when they band together. High trading volumes forced price action like never seen before in stocks like Gamestop, Express, and Nokia.
The dramatic gains gave many people who’ve never invested a penny the drive to jump in. At the same time, COVID-19 economic stimulus checks began hitting bank accounts. According to CNBC, many people used some or all of these funds to try their hands at trading stocks.
The allure of making money on the stock market from the comfort of home caused many new investors to dream of day trading for a living. The explosion of low-cost online brokerages like Robinhood and Stash has made it easier than ever to buy and sell positions instantly.
But what exactly is day trading? And how do you become successful at it?
What Is Day Trading?
A day trade is when an investor purchases a financial instrument and sells it on the same calendar day. The idea is to take advantage of intraday price movements in an attempt to generate significant short-term profits.
Day traders are known for making large trades, often on margins that provide leverage. This is because small price movements on large, leveraged positions can lead to significant returns.
Benefits of Day Trading
Day trading has many benefits for those rare individuals who can manage their emotions and withstand the inherent pressures of day trading:
- Potentially Enormous Profits. Done well, successful day trades can be extremely lucrative and turn a quick profit.
- Independence. Many day traders are self-employed, working by themselves and answerable to no one. They are true entrepreneurs living by their wits and, hopefully, reaping the benefits of their own decisions.
- Euphoria. There are few events that can match the emotional high that comes with a huge profit earned solely through your own efforts and a bit of good luck.
- Status. Day traders occupy an almost mythical status in certain communities, similar in many ways to the legendary “fast guns” of the Old West — iconic outsiders living by their own rules and making their own way.
Risks of Day Trading
As with any style of investing, day trading comes with risks. However, unlike buy-and-hold, growth, or value investing, when you day trade, you’re accepting a higher level of risk due to the short time frame associated with the process. Here are the downfalls you should consider:
Short-term volatility is what traders bank on, but predictions made over a short period of time have a lower probability of coming to fruition, resulting in higher levels of volatility risk.
Think about it this way: if you bet it’s going to rain in the desert today, you have a high probability of being wrong, but if you bet it’s going to rain in the desert in the next five years, your probability of being correct would be much higher.
The stock market works in the same way — it’s almost impossible to predict where prices will move from minute to minute or hour to hour.
2. Margin Risks
Investors who use margins to increase their buying power take on increased risk by purchasing stock with borrowed money. Should your trade go badly, you still need to pay that money back.
In some cases, margin calls will take place, which is when declines cause the balance in your trading account to fall below margin requirements. If that happens, your brokage will require you to put up more capital to cover your risk.
The bottom line is that while margins are a tool traders often use, they’re a double-edged sword.
3. Higher Tax Burden
Returns on investments that are purchased and held for more than one year are taxed at a lower capital gains tax rate.
However, returns on investments that are held for less than one year will be taxed at the same rate as ordinary income. Therefore, short-term profits from day trades experience a higher tax rate than profits from long-term investments.
4. Psychological Addiction
Day trading has the potential to lead to a psychological addiction. As with a gambling addiction, the potential to generate large amounts of money in a short period of time results in a drive to continue whether you’re on hot streak or down on your luck.
Becoming addicted to day trading comes with significant consequences, especially if you’re trading with borrowed money or money you can’t afford to lose.
Is It Possible to Day Trade for a Living?
Day trading is far from impossible. There are plenty of traders who do it successfully. However, as with any other career, those who make the most money as day traders are successful because they have extensive experience, knowledge, and a knack for their craft.
Unfortunately, many newcomers fall victim to the notion that it’s a good idea to quit their jobs today and sink their savings into day trading on the stock market.
The fact is that in doing so, you’re risking your financial security. Day trading is a difficult process that requires complex charting, a detailed understanding of what makes the stock market tick, and a detailed understanding of the psychology behind movements in the market. That’s not something most people have the ability to achieve overnight.
Ultimately, if you’d like to become a full-time day trader, so be it, but plan to do it in steps.
Start by investing for a few years to gain the detailed understanding of the stock market you’ll need to be successful. In the meantime, research trading strategies, charting strategies, and the equipment you’ll need to set up the infrastructure successful traders take advantage of.
Once you feel you have the tools you’ll need to be successful, try your strategies out on a trading simulator and tweek them as necessary. From there, it’s time to try your hand with small trades, slowly working your way up to trading with the pros.
Day trading should never be looked at as a get-rich-quick scheme, as rushing the process will lead to devastating mistakes.
Pro tip: Successful day trading requires finding strategies that work for you. There are many different products available, such as Mindful Trader, where they’ve mastered trading strategies that have a history of profitability. This helps drastically cut down the learning curve to be able to make successful trades on your own.
Common Day Trading Strategies
Trading without a strategy is akin to gambling. So it’s important that you understand and stick to a strategy or group of strategies if you want to get involved in day trading.
Do further research on the mechanics of any strategies that intrigue you before risking your money trying them. Some of the most common day trading strategies include:
Those who use the scalping strategy aren’t looking for massive gains on each trade. Instead, these traders sell their positions as soon as they become profitable.
The idea is similar to any low-margin business. If you only make a little money on every transaction, but are at the center of a large number of transactions, you stand to earn large amounts of money.
This fast-paced strategy is exciting, but it can also be very dangerous.
Because scalpers sell as soon as each trade becomes profitable, a single large loss could wipe out the returns generated over several successful trades. As such, it’s important that your scalping strategy comes with a solid exit strategy.
Fading is a strategy that goes against the grain. Instead of following the trend the financial instrument is taking, traders will go against it.
Because price movements in the market — especially substantial ones — often are overreactions, the fading strategy posits that when a stock price is on an unsustainable run for the top, you can expect investors will soon take profits, sending prices back down.
So, in this case, using the fading strategy, you could short sell the stock, taking advantage of the downswing as profit-takers execute their trades.
Calculating daily pivot points, or simply daily pivots, gives investors a way to determine reasonable support and resistance levels.
Although technical indicators are not always accurate, when a stock reaches support, there is a higher probability of upward movement than downward movement ahead. Conversely, when a stock reaches resistance, downward movement is more likely ahead.
Knowing this, some day traders look for stocks and other assets that are trading at or near the support and resistance pivot points for that day. Depending on which point the value of the asset is closest to, traders will either buy shares or enter into short positions. These pivot points are also commonly used as exit signals.
Some day traders follow a strategy known as momentum trading. The idea behind the strategy is to find stocks that are seeing significant gains and higher-than-average trading volumes. This suggests investors are diving into the stock and increasing demand, which may lead to further price appreciation, signalling traders to buy the stock.
The momentum strategy can also be used on stocks that are falling. For example, if a company announces that it’s filing bankruptcy, shares will likely go on a volatile run downward. In this case, taking short positions at the right time gives a day trader the ability to capitalize on the movement.
Technology has changed the way people do just about everything. Naturally, the stock trading process is changing as well, as robo-trading is becoming more and more popular.
Note that robo-trading isn’t the same as investing using robo-advisors like Betterment or M1 Finance, which focus on long-term investing strategies. Robo-traders are high-end computers that use complex algorithms to generate trading signals and often automatically execute trades on behalf of users.
Of course, robo-trading platforms come with a cost, and it’s often pretty high. But the ability to trade without trading, and do so successfully, is a valuable concept.
Common Assets Targeted for Day Traders
Day traders display a bit of favoritism when it comes to the types of assets they trade. After all, because their goal is to make a large amount of money in a short period of time, it’s important that they trade in assets known for high levels of volatility and liquidity.
Some of the most common assets targeted by day traders include:
Cash is the most liquid asset in the world because everyone wants it. So, naturally, there’s quite a bit of movement on foreign exchange (forex) markets throughout the day.
While currency is constantly seeing price fluctuations, these movements are generally very small. Day traders often remedy this problem by using large amounts of leverage in order to trade far more currency than their upfront cash would allow.
Unfortunately, when things go wrong, this leverage also serves to expand losses, rather than gains.
Stock trading is also very common, but day traders don’t look for just any stock to trade. Instead, they’re looking for highly liquid, highly volatile stocks that are known to create the price action they want to exploit for profits.
This level of volatility is often seen in penny stocks.
While penny stocks often offer up the opportunities that day traders are looking for, the high levels of volatility can lead to significant losses just as fast as it can lead to significant gains.
Day traders didn’t often look at larger companies in the past. However, that’s quickly changing thanks to the group on the WallStreetBets subreddit.
The group showed that regardless of the size of the company, if enough retail traders got involved at the same time, significant price movements could be created.
As such, a new strategy is emerging whereby traders measure the social activity surrounding a ticker, giving it just as much importance as the technical data seen on the stock chart, and hoping to tap into the next Big Short Squeeze.
Options contracts are constantly changing in value as overall opinions in the market change, leading to the sort of volatility day traders often look for. As derivative investments, day traders should understand how options work before diving into trading them.
Commodities are another hot asset among day traders. That’s because while they see slight fluctuations throughout the day, the values of commodities are constantly moving, creating several opportunities in any given trading session.
Tools You’ll Need to Be a Successful Day Trader
If you’re interested in becoming a serious day trader, you should look at it like any other craft. As with any profession, there are plenty of tools that will make your day trading activities more successful.
Moreover, like most businesses, day trading comes with substantial upfront expenses, making it difficult for most beginner investors to enter the market.
The most important tools you’ll need in your toolbox before you get started in the world of day trading include:
1. An Online Brokerage Account or ECN
You won’t be able to make any trades until you open an account with a brokerage firm. Because you want to try your hand at trading for yourself, you’ll need an online brokerage account that offers an intuitive trading platform.
When choosing the online stock broker you’ll be working with, look for the following:
- An Intuitive Trading Platform. The trading platform is where you will execute your trades. Therefore, you’ll want to make sure it provides you with everything you need to do so. This includes quality charting features and stock screeners that are laid out in a way that makes day trading a simple process for you.
- Access to Margins. It’s important that your broker offers access to margins. Day traders use margins to expand their earnings potential.
- Regulatory Oversight. It’s best to work with brokers that are based in the United States and governed by U.S. regulatory agencies.
- Commission-Free. Because commissions used to be charged on every trade made, many day traders used electronic communication networks (ECNs) to reduce the cost of trading. ECNs are automated networks that match buyers and sellers of financial products outside the traditional stock exchanges for a per-share fee. However, today there are plenty of online discount brokers that offer commission-free trading. As such, paying commissions or ECN fees are no longer necessary as long as you choose the right broker.
The most successful day traders invest quite a bit of money into the infrastructure that’s used for their trading activities.
If you’ve seen ads for day trader training classes or even read articles online about the process, chances are you’ve seen pictures of people sitting in front of multiple monitors, each with their own charts displayed on the screen.
The fact is that to be a successful trader, you’ll need to have access to or purchase high-quality computers, routers, monitors, and modems that, combined, will give you access to all of the real-time information you’ll need to make a profit as you day trade.
3. Substantial Capital
You’ve heard the old adage, “it takes money to make money.” That adage is nowhere more true than it is when it comes to being a day trader.
Not only will you need to have enough money to cover the high-tech setup required to be successful, you’ll need substantial capital in order to even qualify as a day trader.
The Financial Industry Regulatory Authority (FINRA) put the pattern-day-trader rule into place. The rule states that if you make more than four day trades over a five business-day period, you’re classified as a pattern day trader. As a result, you’ll need to maintain a minimum trading account balance of $25,000.
The idea behind the rule is simple. First, it stops newcomers from aggressively trading without adequate knowledge of the market. Moreover, it ensures that day traders have enough cash to withstand losses.
4. A Detailed Understanding of the Stock Market
The stock market is a complex system. While investing for the long run is a relatively simple process, day trading is an entirely different animal that requires a much more detailed understanding of the market and its movements.
When day trading, traders use detailed technical analysis in an effort to use the past performance of a financial asset as a way to determine where the value of the asset is headed in the short term. As a result, if you’re going to get into day trading, it’s important that you have time to research and practice charting.
Beyond expertise in charting, the most successful traders also have a detailed understanding of market psychology. After all, they’re not worried about the intrinsic value of a company because they don’t plan to hold it long enough for its price to reach its intrinsic value.
Instead, day traders care about news and how market participants are likely to react to that news. The ability to predict market reactions takes years of experience in the stock market to achieve.
5. The Ability to Set Emotion Aside
Emotion is the enemy of any day trader, but as a human being, you’re likely an emotional creature. So, setting emotion aside is a difficult skill to master.
In the stock market, the emotions of fear or greed often creep into the trading process, leading beginners to chase gains or wait too long to cut their losses. Unfortunately, these are major mistakes that can lead to significant losses in your trading account.
If you want to be successful in the day-trading arena, it’s important that you have the ability to set emotions aside and let your trading strategy guide you when it comes to making decisions in the market.
Many would-be day traders find the concept attractive because they imagine a lifestyle that’s free of the 9-to-5 grind. However, if you’re getting into the process of day trading to escape a full-time job, you’re in it for the wrong reasons.
The fact is, day trading is a full-time job. Some day traders even work more than the standard 40-hour-per-week job would require.
Sure, it is possible to make money as a trader in a few hours per day, but the most successful devote quite a bit of time to the process.
Interestingly, most of the tools above, with the exception of time, tend to come naturally with stock market experience. Trading is a detailed and complex process that those who have never made an investment in the stock market simply shouldn’t attempt.
However, as you invest, you’ll learn the intricacies of the market over time. You’ll also learn how to set your emotions aside and stick to your investing strategy. As such, you should have at least a few years of experience as an investor before you venture into the world of day trading.
The allure of becoming a day trader may be hard to ignore. Ads for day trading courses or “investing gurus” featuring people standing in front of extravagant homes, fast cars, and sleek boats grab the attention of many people, luring them into the world of day trading.
Unfortunately, these ads create a false notion that day trading is an easy process that will lead to overnight riches, when the reality is that becoming a successful day trader requires lots of capital, a large time commitment, and detailed knowledge of what makes the values of financial instruments ebb and flow. As such, it’s not a process for everyone.
If you decide you’d like to try your hand at day trading, it’s important that you do your research and test your strategies before risking your hard-earned money.
Moreover, if you have a relatively low risk tolerance or have a hard time controlling your emotions, it may be best to stay away from the process all together.