What Day Trading Is
At base, day trading consists of frequently buying, selling and short-selling equities in a short period of time, usually reversing out of several positions within the same trading session. The aim is to earn a profit on each trade, sometimes even small profits, and watch those gains compound. The practice can be risky, but also highly lucrative.
Day trading may sound enticing for those looking to make a swift profit, but it can be extremely challenging to make a formidable career out of the practice. In fact, a study published by the University of California, Davis, in 2010 revealed that only 1% of day traders consistently make a living from that practice.
But for the few who can succeed in the high-stakes world of day trading, it likely will consume most to all of their time. It is very much a full-time job.
How Day Trading Works
At its core, day trading is all about stock market volatility; day traders look for stocks that are on the move. Whether it’s positive or negative news which alters a stock’s trajectory, economic reports, corporate earnings, or simply a change in market mood, day traders cash in on rapid change. They enter and exit positions very quickly. Day traders must monitor positions closely, and often make quick, high-stakes decisions. There’s no going to the pub for an afternoon drink hoping the positions they’ve taken will turn out.
Something to note, opportunities are not limited to betting that an investment security will rise in price; traders can also profit by betting on downward price movements. Liquidity is also very important to day traders, even more so than other investors. Since day traders need to be able to move in and out of positions with ease, they need to look out for equities which are highly liquid.
Key Takeaway: Day trading is very much about stock market volatility; day traders look for stocks making moves over short time spans.
Most day trading strategies offer a lot of flexibility, allowing day traders to keep their positions open from a few minutes to a few hours. The amount of time that the position is open depends on how the trade is doing and whether the day trader can seize a profit at that time.
Day traders can consider a variety of markets such as futures, equities, currencies, and options. And they can have access to all the exchanges via a direct access broker. It’s one of the fastest and most affordable ways to engage in day trading.
Methods of the Day Trader
There are various types of day trading, each suited for different styles. They can range from short-term trading, where stocks are held for a few seconds or minutes, to more long-term positions where stocks are held throughout the trading day.
Day trader strategies include:
Scalping: This method seeks to make many small profits on small price changes throughout the day.
Range trading: This method mostly relies on support and resistance levels to make decisions. (Support and resistance levels are concepts which assist traders to fully comprehend and act in the markets. Support refers to a price level where a downtrend is interrupted due to rising demand for an asset. Resistance refers to a level where an uptrend reverses a sell-off.)
News-based trading: Here, day traders take advantage of volatility surrounding news events.
High-frequency trading ((HFT)): This method utilizes algorithms to exploit small or short-term market inefficiencies.
Swing Trading vs. Trend Trading vs. Buy and Hold
While a day trader closes out his positions at the end of each trading day, a swing trader can hold her positions for days to even weeks before selling. In swing trading, since there is more time for an equity’s price to increase, there is also more opportunity to profit. With the right selling strategy, swing trading can be much less risky than day trading. Paper trading can help traders mitigate some risk by allowing traders to practice strategies without risking real money.
By contrast, trend trading involves using a stock’s past price movements to make predictions on its future trajectory. Since trend traders operate on a longer timeline, they can also gauge broader economic trends and business cycles to determine when to buy and sell a stock. This strategy isn’t usually applied by day traders or swing traders.
Meanwhile, buy-and-hold is often hailed as one of the best strategies available to investors. Under this approach, investors buy an asset and hold it for a few years or even decades, if they wish to, no matter what bumps occur along the way. The aim of this highly passive investing style is to ride out short-term market instability and losses in order to maximize returns over the long term. This is the basis for most long-term investing programs like 401(k)s and IRAs.
Buying on Margin
Day traders often use borrowed money to make trades, a method called “buying on margin.” With a margin account, a trader can use the securities they already own as leverage to borrow up to 50% of the value of the security they’re going to buy. Buying on margin can help day traders increase their profits substantially — far more than what they could have made using their own money. But the practice doesn’t come without risks. Leverage magnifies one’s losses when trades don’t work out, resulting in costly margin calls.
Day Trading Rules and Risks
While day trading is neither illegal nor unethical, it can be extremely risky. In fact, the Securities and Exchange Commission warns on its website that the practice can result in substantial financial losses in a very short time.
While conventional investing involves the careful analysis of stocks to determine whether an investment is wise, day traders use state-of-the-art technology and technical analysis to spot intraday trends. The risks to investors can be so grave that the Financial Industry Regulatory Authority has rules in place to monitor this fast-moving practice.
Key Takeaway: Day trading is neither illegal nor unethical, but it can be extraordinarily risky. The SEC warns that it can result in substantial financial losses in a very short time.
In addition to the SEC, FINRA also provides oversight of day traders and enforces certain rules and limitations. For instance, it specifies that a “pattern day trader” must maintain at minimum $25,000 in equity on any day that they day trade. (A non-pattern day trader is only required to maintain $2,000). Furthermore, the required minimum equity must be in the account before any day-trading begins. And if the account slips below $25,000, day trading is not permitted until it is restored.
A day trader may trade up to four times the account’s maintenance margin excess as of end of business of the previous day. If a day trader exceeds that limit, however, the brokerage firm will issue a day-trading margin call. The day trader will then have, at most, five business days to deposit funds to meet that call. The brokerage firm can also charge a commission for these transactions.
Does Cryptocurrency Trading Count as Day Trading?
Another way to get involved in day trading is via cryptocurrencies. But since they aren’t regulated by the SEC or FINRA, at least at this point, investors won’t have to worry about day trading limits.
Day Trading Taxes
Day trading doesn’t qualify for favorable tax treatment. Successful day traders are expected to pay income taxes just like traditional investors in the stock market. In very rare cases, day traders can apply for special day trader tax treatment with the IRS. To qualify for that status, the IRS looks for the following criteria: 1) Profit seeking must derive from daily market movements in securities’ prices, not from dividends or longer-term capital appreciation. 2) Market activity must be high. 3) The investor must be trading with both continuity and regularity.
But for those who aren’t eligible, the following rules apply:
Day traders are required to pay taxes on investment gains in the year they sell.
Day traders may offset gains against losses, but the gains they offset cannot total more than their losses.
If positions are held for a year or less, ordinary income taxes apply to any gains.
Is Day Trading for Everyone?
For a new investor just starting to get into the markets, day trading likely isn’t suitable. Most day traders bring with them substantial training and knowledge about the markets. And with just one bad trade, large amounts of money can be lost very quickly.
Tip: Day trading isn’t usually advised for newer investors. Most day traders possess substantial training and knowledge about the markets.
Unlike brokers who trade other people’s money, day traders are putting their own assets on the line. That’s precisely why regulatory bodies warn investors of the pitfalls associated with this type of trading.
Many professional money managers even shy away from the practice of day trading. They argue that the benefits don’t warrant the risks. But for all the perils, there seem to be some people who can make a great deal of money.