This guide will investigate what day trading is. It will present the reader with various day trading strategies, day trading rules and beginner mistakes to avoid, when to buy and sell, how to limit losses, as well as the pros and cons of using this trading method.
What is day trading?
Day trading is a short-term trading strategy that involves actively buying and selling securities within the same day. It has little to do with investing in the traditional sense. Instead, day trading merely exploits the inevitable price fluctuations that occur during a trading session.
The most commonly day-traded financial instruments are stocks, forex, and cryptocurrency, as well as derivative products such as options, contracts for difference (CFD), and futures contracts. Technically, anyone can day trade, though institutional investors rather than retail traders primarily dominate the practice.
Day trading requires a deep understanding of the markets, financial products, and strategies and involves meticulous market and news monitoring. For example, not only do you have to decide what to trade and when’s the best time to do it, you’ll need to figure out how much capital you’ll need, what equipment and software are required, as well as, how to manage your risk adequately.
Important: If you are completely new to investing, day trading may not be for you. Focusing on a long-term investment strategy is the best way to beat the market and achieve your financial goals. A successful investment portfolio will often be diversified and spread across various asset classes, such as stocks from different industry sectors, as well assets like bonds, commodities, and real estate.
Recommended video: How does day trading work?
Is day trading suitable for beginners?
Unless you fully understand the magnitude of the risks involved and can live with those risks, you should not consider day trading. The U.S. Securities and Exchange Commission (SEC) has issued the following warnings to day traders:
- “Be prepared to suffer severe financial losses”: Day traders typically experience painful losses in their first months of trading, and many may never make a profit. That is why you should never trade with more money than you can afford;
- “Day traders do not invest”: Day traders merely profit from short-term price changes. In fact, they never leave their trades open overnight;
- “Day trading is an extremely stressful and expensive full-time job”: Day trading is unbelievably time-consuming and demands high levels of concentration from the trader. A lot can happen during a trading day, resulting in volatility that can challenge even the most seasoned trader. Additionally, day trading can rack up high expenses, such as large commissions or training and equipment;
- “Day traders depend heavily on borrowing money or buying stocks on margin”: Leveraged investing can result in losing substantially more than initially invested;
- “Don’t believe claims of easy profits”: Every investment involves some risk. However, there are better ways to plan for a solid financial future than engaging in risky trading strategies, especially those involving leverage;
- “Watch out for hot tips and expert advice from newsletters and websites catering to day traders”: Don’t believe any claims touting the easy profits of day trading;
- “Remember that educational seminars, classes, and books about day trading may not be objective”: Research the educational source to make sure it’s legit;
- “Check out day trading firms with your state securities regulator”: Day trading firms have to register with the SEC and the states where they do business. You can confirm this registration by calling your state securities regulator. Find this information on the North American Securities Administrators Association (NASAA) website.
Note: A 2019 research paper analyzed the performance of retail day traders (from 2013 to 2015) in the Brazilian equity futures market (the third in volume worldwide) and concluded that day trading is almost always unprofitable. They found that 97% of day traders that persevered for at least 300 days lost money, only 1.1% made more than the Brazilian minimum wage, and only 0.5% earned more than the initial salary of a bank teller.
Institutional vs. retail day traders
There are two basic divisions of day traders: institutional and retail.
Most day traders are institutional traders, who trade professionally for prominent players such as hedge funds, insurance companies, mutual funds, or pension funds. These traders have a massive advantage over retail traders because they have access to resources such as a trading/dealing desk, hefty amounts of capital and leverage, expensive analytical software, as well as the ability to negotiate trading fees and execution prices.
Institutional traders typically seek profits from arbitrage opportunities and news events. The various resources at their disposal allow them to cash in on these less risky day trades before retail traders can react.
Retail traders (individual traders), however, buy or sell securities for personal accounts. Though most don’t have access to a trading desk, today’s online brokerages often offer access to a diverse range of securities (e.g., options) and real-time analytical data. Still, the limited scope of resources prevents them from directly competing with institutional day traders.
Day trading stocks to buy
Day traders focus on three factors when deciding what stock (or any other asset) to buy:
- Liquidity: Highly liquid stocks make it easier for day traders to exit positions quickly and with less risk of a loss from the bid-ask spread, as highly liquid assets generally show lower bid-ask spreads. Typically, if a stock price moves higher, traders may take a long position, and if the price moves down, they may choose short;
- Volatility: This measures how much an asset’s price will fluctuate on a given day. More volatility means more potential for profit as well as more risk. A stock that moves a lot during the day, is typically the most attractive to a day trader. Volatility can be triggered by several reasons, including an earnings report, investor sentiment, or a news story. Day traders don’t care which way the overall market is moving. So, as long as the stock market is moving either up or down, they can make a profit;
- Trading volume: This measures the number of shares traded in a given period, commonly known as the average daily trading volume (ADTV). High trading volume indicates a lot of interest in that stock, and an increase in volume is often a precursor of a price move, either up or down.
Once you decide what assets you want to trade, it’s time to identify your entry points. For a successful trade, consider utilizing the following financial services and tools:
- Real-time news sources: Day traders should subscribe to constant coverage from news outlets to always be notified of potentially market-moving news breaks;
- ECN/Level 2 quotes: These services used in tandem can give traders a sense of orders completed in real-time. Electronic communication networks (ECNs) show the best available bid and ask prices from various market participants, and then automatically match and execute orders. Level 2 is a subscription service that supplies real-time access to the Nasdaq order book;
- Intraday candlestick charts: Candlestick charts help traders determine likely price movement based on past patterns;
- Analytical trading software: While expensive, trading software is considered a necessity for most day traders. It may include the following: Automatic chart pattern recognition (a trading program that can identify chart patterns); genetic and neural networks (algorithms to predict future price movements based on historical data); broker integration (immediate and automatic execution of trades); backtesting (testing how a strategy would perform using historical data).
Top 5 most common day trading mistakes to avoid
Day trading is only lucrative in the long run and for traders who take it seriously and do their research. So, after you know what you’ll be trading and have your tools set up, it’s time to start preparing a trading strategy. Before you take the plunge, consider these typical day trading mistakes, as they are the primary reasons new day traders fail.
#1 Risking more than you can afford
Determine how much capital you’re prepared to risk on each trade. Many successful day traders bet less than 1% to 2% of their accounts per trade. For example, if you have a $10,000 trading account and can risk 0.5% of your funds on each trade, you limit your loss per trade to $50.
Therefore, ensure that each trade’s financial risk is limited to a set portion of your capital and that you always stick to your intended trading method. By starting small, you limit your losses and reduce the likelihood of an emotional reaction to those losses.
#2 Trading penny stocks
Novice day traders should stay away from penny stocks. While attractive for their low prices, these stocks are often illiquid, and the chances of striking it lucky with them are generally minimal. Moreover, penny stocks can often become delisted from major stock exchanges and are only available over-the-counter (OTC).
#3 Not timing your trades
A mass of orders begins to execute immediately as the markets open in the morning, contributing to price volatility. A seasoned trader may be able to recognize patterns at this point and time their orders accordingly to make a quick profit.
However, for newbies, it may be better to get a sense of the market (for the first 15 to 20 minutes) before making any moves. After that, midday is generally less volatile. After that, the market begins to rally toward the closing bell. So, though rush hours offer the most lucrative opportunities, it’s safer for beginners to steer clear of them at first.
#4 Not using limit orders
Limit orders allow for more precise trades since you choose the price at which your order should be filled. Additionally, limit orders can cut your losses on reversals. Ultimately, if the market doesn’t reach your set price, your order won’t be executed, and you’ll maintain your position.
A limit order (as opposed to a market order, which refers to the immediate purchase or sale of a security at the current price) sees an order executed at (or better) your set price level. While the price is guaranteed, filling the order is not, as limit orders will only be executed if the price meets the order qualifications.
For instance, a buy limit order will be filled at the limit price or lower, whereas a limit sell order will be executed at the limit price or higher.
Note: Day trades can also set up a stop-loss order to manage losses or lock in profits. A stop-loss order is an offsetting order that gets you out of a trade if the stock reaches a specified price (the stop price). For a buy order, a stop-loss can be placed under a recent low, and for a sell order, above a recent high. Unlike a limit order, a stop-loss order executes a market order when triggered, and its execution is guaranteed once the stop-loss price is met.
#5 Not sticking to the plan
There is a golden rule in trading: “Plan your trade and trade your plan”. Volatile markets can really test a day trader’s patience. So accept the emotions, but don’t let them drive your trading decisions. Instead, calm your mind, reject impulsive decision-making, try to take an objective view, and stick firmly to your trading strategy. Adhering to your formula is essential rather than trying to chase profits. Success in day trading is unthinkable without discipline.
Day trading strategies
Day traders can choose from various day trading strategies. Some of the most widespread techniques include:
- Following trends/momentum trading: This strategy assumes that trends will continue, so you will want to follow them. This means buying when prices are rising or shorting when they drop;
- Contrarian investing/fading: This method assumes that a rising price will eventually reverse and start to decline, and vice versa. A contrarian trader will buy an asset that has been falling or short-sell a rising one;
- Pullback trading: This strategy tries to optimize pullbacks (dip in price from a recent peak) in established uptrends to buy shares at a decreased price and then sell when the value goes up again;
- Scalping: This strategy involves exploiting the small price gaps in the bid-ask spread. Scalpers typically make hundreds of trades on a given day, only keeping trades open for minutes or even seconds. Trading in large volumes is vital for this technique to be successful;
- Arbitrage: Profiting from the short-lived tiny differences in price by simultaneously purchasing and selling an asset in different markets;
- Breakout trading: This method looks for moves outside of an established range and assumes that once the price breaks through the range, it will resume moving in that direction for some time. A breakout occurs when a security’s price breaks above the resistance or below the support level;
- Range trading: Unlike breakout trading, in which you wait for stocks to go above or below the range, in range trading, day traders will buy and sell when prices come near the limits of that range. As a result, the range trader purchases the asset at or near the low price and sells (or shorts) at the high;
- Trading the news: This method sees the trader basing their trading decisions on noteworthy news events, which typically can lead to enormous volatility in the market, resulting in higher profits as well as losses;
- Price action trading: Price action trading ignores an asset’s fundamentals and is, therefore, entirely dependent on technical analysis tools. Here, the trader relies on price movement, chart patterns, trading volume, and other raw market data to determine whether they should enter a trade;
- Market-neutral trading: A risk-mitigating strategy in which a trader will take a long position in one asset and a short position in another related asset;
- Algorithmic trading: Also referred to as an automated trading system, algorithmic trading is a method of automating trades using a computer program following an algorithm (a defined set of instructions). Because the algorithm can be based on time, price, quantity, volume, or any mathematical mode, algorithmic trading can utilize various strategies, including trend-following, scalping, or arbitrage opportunities. Though hedge funds and investment banks typically use algorithmic trading, retail traders who wish to employ this method can buy commercially available algorithmic trading software or build their own;
- High-frequency trading (HFT): Most algorithmic trading falls into HFT. HFT uses automated algorithms to trade securities in large amounts as fast as possible. Unique computer systems are necessary for this kind of day trading, which is why this is not particularly accessible for retail traders.
Testing your strategy
Before you use your chosen trading strategy, you should test it on your demo account. A demo account is a simulated trading environment that allows an investor to get used to a trading platform/software before funding the account or placing trades.
If you can take profits in this simulated environment over two months or longer, proceed with day trading with actual money. If the strategy isn’t profitable, start over.
However, while demo accounts allow traders to test strategies without facing the risks associated with the real markets, simulated results rarely correlate to actual trading results. Remember that execution, capital, and emotions can differ when trading with real capital.
As you practice in your demo account, experiment with different methods to find the most suitable for your trading style, financial objectives, and risk tolerance. Indeed, many day traders will use a combination of techniques depending on market behavior and the type of asset traded.
Pattern day trading
The pattern day trader (PDT) designation is dictated by the Financial Industry Regulatory Authority (FINRA) and differs from a standard day trader by the number of trades executed in a specific time frame. A pattern day trader is a stock trader who completes “four or more day trades within five business days” using a margin account and is subject to additional regulatory limitations set by FINRA, including:
- Maintaining a minimum of $25,000 of equity in your account at all times. If the balance falls below that, you won’t be allowed to day trade;
- Not trading more than your “day-trading buying power,” typically up to four times the maintenance margin excess (the amount above $25,000) as of the previous trading day’s close.
Note: Leverage granted by margin tends to amplify gains as well as losses. For example, should the value of assets bought on margin rapidly decrease, an investor may not only have to repay their initial equity stake but also the capital they borrowed from their broker to make a leveraged trade (plus any interest or commissions). In addition, in the event of a loss, a margin call may instruct your broker to liquidate securities without prior consent.
Pros and cons of day trading
Under the right circumstances, day trading can be incredibly lucrative. But like any investment strategy, profits are never guaranteed, so beginners should carefully consider the pros and cons to decide whether they’re the right candidate for this trading strategy.
- Day traders can speculate on various markets, including stocks, forex, commodities, as well as derivative products like futures contracts;
- Allows traders to benefit from both positive and negative price fluctuations;
- Because all trades need to be closed at the end of the day, day traders don’t need to worry about an overnight news event causing significant moves to their positions;
- Returns on investment can compound more quickly (assuming you are making a profit) than with long-term investment strategies;
- You can be your own boss: Individual day traders don’t have to answer to anyone but themselves.
- Requires quick educated decisions and execution of a high number of trades in a day;
- Though you don’t need to trade all day, you’ll have to be on high alert for potentially market-moving news or developments;
- Because of the number of trades, trading costs in the form of commissions and fees will quickly add up, potentially cutting into your profits;
- Short-term capital gain (gain held for less than a year) is still taxed at the same rate as your income;
- Successful day trading demands scrutinous planning: hours in front of the computer checking the market, keeping up to date with news, maintaining a spreadsheet, and plotting out your next move;
- It requires a large sum of capital: Day trading stocks in the U.S. requires a trading account balance of at least $25,000.
Although apps opened the market to those with no prior investment experience, day trading is not something to be taken lightly, and it can have serious financial consequences if you aren’t fully aware of the risks involved.
Ultimately, the odds are stacked against the day trader and in favor of the long-term investor. This is because, over the long term, the value of stocks generally rises, both individually and collectively.
However, if you still want to try your hand at day trading, ensure you thoroughly understand the markets you will be navigating and how to manage your capital through the inevitable ups and downs that day trading brings. Most importantly, find a method that you’re comfortable with and can implement consistently, and ensure you have access to the necessary resources and cash to have a chance at succeeding.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs about day trading
What is day trading?
Day trading is the practice of exploiting price movements in securities. It sees the trader place numerous buy and sell orders daily, never leaving trades open overnight.
How to start day trading?
You will first need to decide what markets you want to trade in and how much capital you need. You will also need analytical trading software, access to a trading platform, as well as real-time market quotes. Lastly, before jumping into live markets, you should practice trades using a demo account.
How to get good at day trading?
Before you open a real trading account, consider practicing your strategies using a demo account or a trading simulator. Typically these are offered by your broker or trading platform. It’s the safest and easiest way to practice your strategy without risking capital. Novice day traders should expect to practice for at least two months with profitable demo performance before transitioning into live markets.
What stocks are best for day trading?
The best day trading stocks have high price volatility, liquidity, and trading volume. Volatility in any direction lets traders take advantage of price movements, while trade volume provides the opportunity to get in and out of positions fast.