You may have heard of some of the world’s most famous day traders—building fortunes well into the millions and even billions of dollars. Some of them have sustained their wealth, while others have been involved in scandalous deals and plagued by bad trades. If you’ve ever wondered how day trading works, or perhaps you’ve become interested in this fast-paced trade strategy, you’re in the right place.
In this article, we’re breaking down day trading basics to give you an overview of how the industry works and what a day in the life of a day trader looks like. Of course, day trading (and investing in general) opens the door for a substantial amount of financial risk, so always follow the right strategy for your own budget and assets.
What is Day Trading?
According to the U.S. Securities and Exchange Commission (SEC), day trading is a method of trade in which individuals buy and sell stocks online rapidly throughout the day. Traders make these transactions hoping that they can cash in on small changes in their assets’ sale price, and ultimately turn a profit.
Note: The name is intentional—the SEC says true day traders hold onto their shares for no longer than a single day.
Day trading is known to be an extremely risky type of trade, due to the huge amount of capital day traders put toward their shares each day, and how quickly market prices can change as the day goes on—sometimes within seconds. Day trading has relatively small profit margins compared to some longer-term trade and investment strategies, which can mean a lot of capital spent, with not a whole lot returned; or worse, a lot of capital spent, and lost shortly thereafter. But these risks and rewards don’t keep people from trying their hand at online trading. According to a survey of modern traders from BrokerNotes, there are approximately 3.2 million online traders in Asia and 1.5 million in North America, with day trading among the most popular types of online trading.
Due to the extremely short timeframe that traders hold onto their assets, day trading is not actually the same thing as investing. Rather than cashing in on minute changes in share price (like day traders), investors tend to hold onto their investments for years or even decades to take advantage of interest, dividends, and stock splits, in hopes that they make a profit once they decide to sell.
Day trading is sometimes considered a full-time job and is done online so that individuals can keep track of their securities (shares) in real-time. Using online trading platforms, traders can evaluate the best time to buy new shares, and sell their current assets. This decision is typically based on the trader’s perceived highest value that they can sell their shares/securities before they call it quits for the day. The market fluctuates quickly, so this process requires close attention.
Risks of day trading
As we mentioned before, day trading is considered an extremely risky trade method for a number of reasons that the U.S. Securities and Exchange Commission (SEC) details in their Day Trading: Dollars at Risk publication. Here are some of the risk factors traders and consumers should consider before diving into the “tricks of the (day) trade”.
- Financial losses can be extreme: Because of the small timeframe and very limited insight on how stock prices will fluctuate in just 24 hours, the financial losses from day trading can be devastating. Day traders often front a significant amount of capital to buy shares, which can decline at only a moment’s notice. The SEC says traders should never use money that they need for daily living expenses or loans, and only risk money they can afford to lose.
- Day trading can be stressful: In order to make the most profitable trade decision, day traders must watch the changing market very closely. For most, this means keeping a close eye on their computer all day and using strategy to predict profitable market trends. To say day trading isn’t for the casual consumer is an understatement, at least according to the SEC’s warnings.
- It’s not cheap: On top of funding their trade capital, most day traders must also payday trade firms commissions, and sometimes training fees to learn how to day trade properly.
- Borrowed money adds risk: Many day traders use borrowed money to finance their securities, which can incur interest fees and potentially put the trader in a position of over-borrowing. We’ll talk more about borrowing trade money in a moment, but the SEC advises those considering day trading to have a solid understanding of how margin borrowing works before trading on borrowed capital.
- Beware of promised profits: Day trading can be extremely profitable for those with the right strategy and know-how, but the SEC says new traders should be wary of publications and ads from trade firms guaranteeing major profits. Before starting to trade with a firm, consider doing some of your own research. Ask how many of the firm’s clients have lost money and compare that number with how many have made a profit. If they do not claim to know this information or aren’t transparent about it, you might reconsider trading with a different firm.
- Not all day trading firms are created equal: Another way to assess your trading firm options is by calling your state securities regulator. Your state securities regulator can verify whether or not the firm is registered with the SEC, and if they have a problematic history with regulators or customers. Knowing this information ahead of time can help you avoid partnering with an under-qualified firm.
Why do so many day traders fail?
In his How to Day Trade guide, experienced day trader and trading coach Ross Cameron says only 1-in-10 day traders will be able to make a living out of their day trading career. Cameron says this is due in part, to his top reasons day traders fail, which include:
- The hunt for the holy grail—Traders who hop from one strategy to the next without taking the time to refine their strategy. This can lead traders to make reactive decisions rather than follow their carefully considered plans.
- Negative profit/loss ratios—Investopedia defines profit/loss ratio as the average profit compared to the average loss per trade. When a profit/loss ratio is negative, the trader holds themselves to a higher success rate than may be possible, which could mean their trades end up in the red.
- Fear of loss—Day trading is an inherently risky trading strategy, but Cameron says many traders fail when they let fear get the best of them. This can lead some traders to make emotional decisions, rather than sticking to strategy—sometimes resulting in massive financial losses.
- Holding losers too long, selling winners too soon—Many beginning day traders are tempted to stray away from strategy because of emotion or by following inaccurate market indicators. Cameron says traders must know when to cap their losses and how to interpret indicators to make the most out of their trades.
- Not accepting loss as part of the business—There are days you may turn a substantial profit and others where you’ll lose out on trades. But accepting your capital casualties could help you find a balance to cap your losses and in turn save you from losing even more on a trade.
How to Day Trade
Now that you know what day trading is, and you’ve considered both the risks and potential benefits, we can dive into some day trading basics to help you start your trading career on the right foot.
1) Use your best resources
Trading can be an extremely elusive industry to tap into and succeed within. Why? Most of the best in the biz are reluctant to share their trade secrets because if you catch onto their strategy, they could lose out on their own profits. This secretive nature is what can make day trading so lucrative for some, but even harder to navigate for others.
To better understand the ins and outs of day trading beyond this basic guide, many traders enroll in day trading courses where they can learn various strategies and glean insight from experienced traders. If this sounds like the right learning trajectory for you, you might consider these tips when looking for a day trading course.
- Verify that the instructor has 10+ years of trading experience
- Stick with traders and courses that have a long track record of success
- Choose a trading course that teaches students how to trade for themselves, not rely on ongoing fees and classes
Keep in mind that your success in a trading course will depend on your commitment, too. To further your day trading education, you may wish to sign up for forums and day trading groups that can keep you in the loop with industry changes.
Of course, doing your own fact-checking is an important part of the process as well, so consider varying your sources of information by following a few different finance publications and market reports. Doing this may help you stay in the know when markets or industries change in a way that might impact your shares or trading strategy.
Talk the talk
In order to make solid day trading decisions, you’ll need to understand what makes a good deal. To establish some introductory lingo, let’s review a couple of terms:
- Liquidity: an estimate of how easy it may be for a shareholder to convert an asset into cash.
- Volatility: a measure of how much a stock price might change, and at what speed—for day traders, high volatility often means bigger profit margins.
2) Get the right equipment
- A broker: In order to execute your trades, you may need a trading account with a broker. Your broker will take your direction when you want to buy and sell trades. In return for this service, you will need to pay your broker a commission fee, which varies between brokerages. When choosing a broker, you may consider the commission rate, whether they offer customized trade solutions, and the type of trade software they use.
- Note: If you already have trading software that you prefer, this may influence which brokerage you choose as some have integrated software solutions, and other brokers allow you to choose your own.
- Computer, laptop, smartphone: Day trading requires close-to-constant attention throughout the trade day—so if you’re planning on tracking the market’s every move, you’ll likely want to have a device that can help you do just that. Remember, the stock market can change very quickly, so a computer that takes a long time to load or process programs probably isn’t your best bet. If you’re trading with a broker, you’ll also want to have a direct line to your broker in case you need them to act quickly on making a trade. Pro Tip: Keep their phone number programmed in your phone in the event that the internet cuts out or slows down. This way, you’ll have them on speed dial and be able to make changes to your shares efficiently.
- Strong internet: A good internet connection is an indispensable resource for day traders. Even a minute or seconds of lag time could jeopardize your chance at selling your shares at their highest point—or buying new ones at a low entry point.
- Access to a trading platform: In order to trade your stocks and monitor market data, you’ll need to have access to a high-quality trading software program. Most brokers provide traders with a variety of options, but the main takeaway is this: it should be easy for you to access various price and timed charts; and making trades should be simple, with minimal procedures involved.
- Market data: Your trade software and broker may give you information on your own share data, but you may also want to take other sources into consideration as you strategize and identify trends. Some brokers will include all market data, while others will need you to indicate which data you’re interested in—such as NYSE or NASDAQ stock exchanges, or data on other types of securities, like futures.
3) Get funding
The old saying goes “You need money to make money,” and there is really no better example out there than day trading—it can be seriously expensive to make money in this industry. But the reality is, most day traders solicit the help of a brokerage firm to fund their trading ventures.
Just like a bank can lend you money against the value of your home with a home equity line of credit, a brokerage firm can lend traders money against the value of their stocks and assets. In the trading industry, this practice is called margin borrowing. Depending on the types of assets you’re trading, your brokerage firm will determine how much of your assets are marginal. And just like any other loan type, margin loans can accrue interest. Borrowing on a margin can be a viable solution for investors and traders looking to borrow for a short period of time, but it’s important to consider the costs associated before signing a margin agreement.
Additionally, traders borrowing on margin may familiarize themselves with the margin rules established by the Financial Industry Regulatory Authority (FINRA). These regulations apply to any trader defined as a “patterned day trader” by the trader’s partnering brokerage firm.
How do I know if I’m a patterned day trader?
Your broker uses guidelines from FINRA and the Federal Reserve to determine which traders are considered patterned day traders. If you’re unsure how your brokerage firm qualifies your trade relationship, contact your broker to see if the margin rules apply to you before borrowing or trading.
What do the margin rules say?
If you are considered to be a patterned day trader, the following rules may apply to your trading and borrowing operations:
- You must maintain minimum equity of $25,000 on any day you trade
- Your minimum equity must be in the account prior to any trading activities
- If your account falls below the required $25,000 minimum, you will not be allowed to day trade until you reach the requirement
There’s no set rule on how much money you need to day trade—though, your brokerage firm may have their own specific requirements and recommendations. The takeaway is, traders should adhere to the investment standard that you should not invest more than what you can afford to lose.
4) Pick a trading strategy
Deciding on which strategy is best for your day trading operations is probably one of the most challenging parts of the process because it’s ultimately up to your own budget and preferences. Let’s discuss a few of these methods to help you find one that makes sense for your own unique trading style.
Basic day trading strategies
According to Investopedia, there are four basic day trading techniques that traders might employ as they start to search for profits:
- Trend: Following the trend is when a trader buys when prices are rising, or short sells when they drop. This kind of trader interprets market signals and acts on those trends, trusting that they’ll make for consistent profits if the trend stays the same.
- Contrarian investing: Contrary to trend followers, contrarian traders assume that market trends will change dramatically—and quickly. This perspective leads these traders to buy when prices are falling and short sell when prices are rising.
- Scalping: Traders who subscribe to the scalping method rely on exploiting small price gaps as they buy and sell shares at an extremely high volume and fast pace. Some traders will even buy and sell their shares within seconds.
- News: Those who trade on news react to good news on the market by buying shares, and bad news by selling them. This strategy can lead to a higher volatility, which can translate to higher profits.
5) Manage day trading risks
Even if you’ve found what seems like an invincible trading strategy, you’ll always have to perform some level of risk management to minimize your trading losses. Here are two potential ways to help minimize your losses and maximize your profits.
- Daily Stop Loss: Many day traders implement a daily stop-loss policy to help avoid losing money on day trade shares. A daily stop-loss basically outlines how much money the trader is willing to sacrifice in a day before closing up shop. This can help traders stick to a calculated strategy, rather than making reactive decisions based on how their trade day is going. Your stop loss may fluctuate from day to day, but many successful day traders say the important thing is to stick to whatever your stop-loss percentage is, and hold your broker to stopping at that predetermined point—no matter how things change as the hours go by.
- Use Reliable Resources: Using diverse, trustworthy resources is a great way to protect yourself from big losses and missed profits. Day traders may want to consult both their brokerage’s market data and information from independent sources to ensure they’re getting the full picture before making any major decisions.
6) Evaluate and adjust
Like all types of investments, it’s important to always take a look at your data and adjust where you need to. By taking a look at historical information, you may be able to identify a new approach that might actually work better than your initial plan.
Other Types of Trading
Perhaps after all of this, you’re thinking—maybe day trading isn’t exactly right for me. And that’s okay! Each type of trade style involves different trade processes and holding periods that can impact how risky a trade might be, and its potential for profit (with the right strategy in action). Take a look at how these trading styles differ in how long traders/investors hold onto their assets.
Takeaways: Day Trading Basics
Day trading is an extremely risky financial endeavor, but it can also be an extremely profitable one. Use this guide to help you weigh the risks and benefits, learn day trading basics, and explore which trading strategies might make sense for you.