Day trading involves buying and selling a stock, ETF or other financial instrument within the same day and closing the position before the end of the trading day. Years ago, day trading was primarily the province of professional traders at banks or investment firms. With the advent of electronic trading, day trading has become increasingly popular with individual investors.
A word of caution
While day trading can be profitable, it is risky, time-consuming, and stressful. The majority of non-professional traders who attempt to day trade are not successful over the long term. Success requires dedication, discipline, and strict money management controls.
Variety of methods
Day traders use a variety of strategies. Most common strategies are simply time-compressed versions of traditional technical trading strategies, such as trend following, range trading, and reversals. In recent years, trading technology has evolved to the point where some individual day traders may place dozens or even hundreds of trades per day in an attempt to capture a large number of small profits, through techniques such as scalping or rebate trading. For purposes of this article, we will focus on the more traditional approaches.
In the parlance of day trading, a breakout occurs when a stock or ETF has surged above a significant area of price resistance. The breakout could occur above a consolidation point or above a downtrend line. A breakout can also occur on the downside. In that case, the instrument falls below a significant area of support, which can be either a consolidation point or below an uptrend line.
When an upside breakout occurs, breaking resistance, it’s important to look at the level of trading volume. If the breakout occurred on a surge of volume, the odds are better that the breakout will remain intact and price will not fall below the previously broken resistance area.
The question that day traders constantly face is whether to aggressively “chase” a breakout and get into the market quickly or wait for the price of the stock or ETF to retreat a bit and confirm the breakout. A number of factors can come into play in making that decision, including: the underlying fundamental catalyst for the breakout; the medium and long-term trend direction of the instrument; the behavior of other related markets; and the trading volume attendant to the breakout. To the degree these factors support the breakout, it’s more likely that prices will surge significantly higher and the trader may then be justified in aggressively chasing the breakout.
One of the chief tenets of technical analysis is that a prior area of resistance becomes the new level of support after the resistance is broken. Thus, in the case where a breakout is not supported strongly by the factors described above, a time-honored strategy is to place a buy order just above the breakout point and place a stop-loss just below the broken resistance line. The idea is that price will retreat, confirm the new support level, and then move higher again.
A pullback entry is based on the concept of finding a stock or ETF that has a clearly established trend, and then waiting for the first retracement (pullback) down to support of either its primary uptrend line or moving average to get into the market. For day trading purposes, a trader may identify a stock or ETF that has shown a good deal of upside strength in past several trading days. The idea is then to jump into the market after the market retreats to a support level.
With pullback trading it’s critical to ensure that a clearly defined trend is already in place. Otherwise, you risk entering the trade too early. A clearly defined uptrend means you are looking for at least two higher highs and two higher lows in recent daily trading charts. A clearly defined downtrend would be two lower lows and two lower highs. That’s the minimum requirement.
A key point to remember here is the basic rule of trend trading: the longer a trend has been intact, the more likely the established trend will continue in the same direction. If a stock or ETF has been steadily tending higher for several weeks, the odds are much greater that it will continue higher as opposed to a market that has been trending higher for only a few days.
It’s understandable to resist entering a long-established trend. You may look at the price chart and sense that “you’re too late to the party” and the trend is about to end. While that reaction is completely understandable, it is often wrong. Here’s why: When institutions start buying ETFs or stocks, they typically continue to invest until the trend ends and/or the next promising idea comes along. Thus, there is typically a good deal of buying interest at support areas in any clearly defined trend.
Risks of day trading
Many day traders trade on margin that is provided to them by their brokerage firm. Margin is essentially a loan to the investor and it is the decision of the broker whether to provide margin to any individual investor. Brokers are mandated by law to require day traders have $25,000 in their accounts at all times. If the investors account falls below $25,000 the investor has five business days to replenish the account. If the investor fails to replenish the account, he or she will be forced to trade on a cash-available basis for the next 90 days and may be restricted from day trading.
Even if the investor is not utilizing margin, the $25,000 account minimum applies. If you trade four or more times in five business days, and if the value of those trades is more than 6% of that periods total trading activity, the investor will be identified as a “pattern” day trader under NASD Rule 2520. Thereupon, the investor is required to maintain a $25,000 account minimum, or face restrictions on trading.
Margin trading entails greater risk, including but not limited to risk of loss and incurrence of margin interest debt, and is not suitable for all investors. Please assess your financial circumstances and risk tolerance prior to trading on margin.
A final word
Again, day trading is very difficult and if you decide to play the game, you’ll be competing against professional traders. It’s important that you educate yourself, find a method that you’re comfortable with and can implement consistently, adhere to strict money management rules, and be prepared for the inevitable ups and downs that all day traders experience.