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Academy Center > Trading
Futures | Forex | Technical Analysis
Market Analyst, TradersLog.com
College of Wooster
Day trading, once exclusively the domain of financial professionals, is now firmly in the mainstream and available to the general public. This has been made possible by the ubiquity of high speed internet, powerful computers and the evolution of the brokerage industry. Most US brokers have lowered the barriers to entry to the extent that there is no minimum deposit to open a trading account. Commission-free stock trading is the norm and fractional share trading has made it possible to trade high-priced shares even if you have a tiny account balance.
The appeal of day trading is easy to understand, with the freedom of working from your home and the large potential financial gains. Communities of self-directed traders such as Reddit’s wallstreetbets have sprung up and retail traders now represent a substantial percentage of the overall equity trading volume in the US. In this article, we’ll cover the basics of day trading, how to start and the risks and opportunities involved.
Day trading is a short-term style of trading that aims to capitalize on intraday price movements. By definition, a day trader may make many trades within a day, but will close their positions before it ends. The goal is to lock in quick profits from price fluctuations during the day. In doing this, day traders avoid the risk of holding market positions overnight and they also don’t have to pay any interest on the margin they use. Margin balances accrue interest after settlement, so day traders typically don’t pay margin interest fees.
Other trading-related terms you may have heard mentioned are scalping, swing trading and long-term investing. Scalping refers to hyper short-term trading, where trades are usually entered and exited within seconds or minutes. Swing trading describes a trading style where market positions are held for days, weeks or months. Positions held for over a year are usually described as long-term investing.
There are several important requirements to become a day trader. Here are some of the key points to keep in mind:
Here are some of the most popular types of trading strategies that are used in day trading:
Moving averages and oscillators such as RSI and MACD are among the best indicators for day trading. Moving averages are helpful in identifying trends and oscillators show when momentum is strong and when it is beginning to fade. Volume (the total number of shares or contracts exchanged), is an important indicator for gauging the strength and significance of a price move.
Keep in mind that day trading strategies do not have to be complicated. Some of the best day trading strategies have only a few rules or parameters.
Many newcomers want to know how to pick stocks for day trading. The best stocks for day trading are typically highly liquid, meaning that they can be bought and sold easily without impacting the price. Day traders can also benefit from major price movements, so another quality to look for is volatility. The more a financial instrument moves, the more opportunity there is for day traders. Stock screeners are available that can identify stocks above set price levels (which will weed out illiquid penny stocks) and stocks that regularly have high volatility.
The studies that have been made on the success rate of day traders are sobering. Evidence suggests that the majority of day traders fail, so it would be fair to say that for the majority it is not worth it. For the few that succeed and can endure the rigors of day trading, it can prove to be worth it, at least in financial terms.
Famous studies that have highlighted the difficulty of day trading include the following:
Having seen such statistics you might ask yourself if day trading is just gambling. While gambling is something usually done for pleasure, the odds of success in professional day trading are often not very different. Like gamblers, day traders should only risk money they can afford to lose.
Another point to remember is that when you make a profit from trading you have a capital gain, which in the United States typically results in a capital gains tax. Profits from assets held for longer than a year are known as long-term capital gains, while profits from assets held for less than a year are called short-term capital gains. Long-term capital gains are typically taxed at a lower rate than short-term capital gains.
While highly risky, day trading is legal. Traders must be careful in selecting brokers and be wary of loosely regulated or completely unregulated brokers that may be situated offshore and provide little or no legally mandated protection in the event of their insolvency.
In the United States, an individual is designated as a Pattern Day Trader (PDT) if they execute four or more day trades over five business days using a margin account. Financial Industry Regulatory Authority (FINRA) rules require that Pattern Day Traders must have at least $25,000 in their margin accounts in order to day trade.
Pattern Day Trading covers trading in stocks and equity options. Requirements for day trading in other markets can be less stringent. For example, day traders in the futures market are not required to meet the $25,000 minimum account balance.
The amount of money necessary to day trade varies by the market you are trading. For example, it is possible to day trade the forex and CFD markets with as little as $100. In addition, there is typically substantial leverage available.
To day trade the futures market the barrier to entry is higher. In the case of futures, individuals can day trade as long as they meet the minimum margin requirements for their positions. It is possible to day trade the futures market with as little as a few thousand dollars.
Day trading stocks on margin requires more capital, due to the Pattern Day Trader (PTD) rule. The definition of a pattern day trader is one who executes four or more day trades in the same account, within five business days. Pattern day traders must maintain at least $25,000 in their margin account on any day that they day trade.
The figures mentioned above are the bare minimum and it’s worth noting that many traders struggle due to being undercapitalized. They may have a good strategy but be forced to stop trading due to a series of consecutive losses. It may be worth waiting to day trade until you have the level of capital where you only need to take a small amount of risk on each trade to reach your profit objectives.
Day traders rely on a variety of sophisticated tools to gain an edge in the markets. These range from their computer hardware setup to analytical software, market data and the platforms through which their trades are routed.
In the high speed world of financial markets, it’s crucial to be able to operate as fast as possible with minimal interruptions. The following are core elements of a day trader’s computer rig:
Direct market access allows traders to send their orders directly to specific exchanges such as Nasdaq, ARCA and BATS. This enables faster order execution, which is naturally preferable for day traders. Unlike most retail brokers where $0 commissions are standard, brokers offering direct market access typically charge commissions. However, direct order routes offer rebates that can potentially lower your trading costs. In the US there are a number of specialized brokers (for example Lightspeed Trading, Cobra Trading) who offer direct market access and cater to the needs of day traders. In addition, some giants of the retail trading world such as Interactive Brokers also provide direct market access through their platforms.
Level II quotes are an important tool for day trading stocks. Essentially, Level II is the order book for Nasdaq stocks. It goes beyond showing the current bid and offer by also displaying the bids and offers at other prices. In this way it provides what is referred to as ‘market depth’.
This allows individual day traders to see the number of shares that market makers, ECNs (electronic communication networks) and other market participants are looking to buy or sell at each price level. Level II data helps traders understand the supply and demand at different prices and gain insights into what large institutional traders are doing.
Market screeners (sometimes called scanners) are a popular tool among day traders. Screeners can be used to rapidly filter through thousands of stocks to find ripe opportunities to focus on for the day.
Some screeners are browser-based and available for free via websites like this one. (Click here to view the investing.com stock screener). Others are software that can be accessed via a subscription, for example TC2000. Some leading brokers have powerful screening software built into their platforms. Notable examples are Screener Plus in the Charles Schwab StreetSmart Edge platform and the Interactive Brokers TWS Market Scanners.
The following are examples of how screeners are used by day traders:
Day traders often use technical indicators, for example moving averages and oscillators. These are built into most charting packages along with drawing tools such as trendlines and studies such as Fibonacci retracement levels. Day traders typically use charts on lower time frames, like the 5 minute or the 15 minute chart. To the trained eye, Japanese Candlestick charts convey a great deal of information about the psychology of the market and are the most commonly used chart type.
Hot keys are an important tool for day traders because they allow you to get in and out of the market as fast as possible – with a single keystroke. The order size, order type and even the direct access routing destination of the order can be preconfigured. Hot keys can also be set up to perform functions like ‘cancel all open orders’. This is particularly useful in an adverse situation, for example if there is a surprise move in the market caused by a major news story.
News feeds from sources such as Bloomberg, Reuters and CNBC help day traders stay on top of the latest market moving stories. This news includes key data such as earnings results, figures from economic releases and major geopolitical news.
When opening an account at a brokerage firm, you can elect to have either a cash account or a margin account. In the case of a cash account, your buying power is limited to the money available in your account. A margin account allows you to borrow money from your broker to fund your trades. Cash and margin accounts have unique advantages and disadvantages, but for day traders a margin account is typically preferable.
Key features of a cash account:
Key features of a margin account:
The Head and Shoulders Top takes place during an uptrend and is defined by three prominent highs with a middle peak, (the head) that is higher than the other peaks (the shoulders). A trendline called the neckline is drawn connecting the two price lows that take place between the head and the shoulders. The Head and Shoulders Top is a bearish reversal pattern and price falling below the neckline with strong volume is typically used as the sell entry signal.
The Head and Shoulders Bottom takes place during a downtrend and is defined by three prominent lows with a middle trough, (the head) that is lower than the other lows (the shoulders). The neckline is drawn connecting the two price highs that take place between the head and the shoulders. The Head and Shoulders Bottom is a bullish reversal pattern and price rising above the neckline with strong volume is typically used as the buy entry signal.
The Double Top pattern takes place during an uptrend and is made up of two consecutive peaks at roughly the same price level, with a moderate trough in-between. The Double Top is a bearish reversal pattern and the sell entry is typically initiated when price breaks below the support level of the trough in-between the two highs, with strong volume.
The Double Bottom pattern takes place during a downtrend and is made up of two consecutive lows at roughly the same price level, with a moderate high in-between them. The Double Bottom is a bullish reversal pattern and the buy entry is typically initiated when price breaks above the resistance level of the high in-between the two lows, with strong volume.
The Bull Flag pattern takes place during an uptrend and resembles a flag on a pole. The uptrend forms the pole of the flag and is followed by a pullback with price making lower lows and lower highs. Parallel upper and lower trendlines can be drawn, which form the flag. The buy signal takes place when price breaks out above the resistance of the upper trend line forming the flag, with strong volume.
The Bear Flag pattern takes place during a downtrend and resembles an upside down flag on a pole. The downtrend forms the pole of the flag and is followed by a retracement with price making higher lows and higher highs. Parallel upper and lower trendlines can be drawn, which form the flag. The sell signal takes place when price breaks out below the support of the lower trend line forming the flag, with strong volume.
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