What is a Day Trader?
A day trader is an individual who opens and closes all of his or her trades before the end of the trading day; no open positions are maintained overnight. Day traders aim to utilize intraday market price action by executing multiple long and short trades, looking to capitalize on temporary supply and demand inefficiencies in market pricing.
If an individual opens and closes trades four times in a five-day period, and those trades account for more than 6% of his or her trading activity, the individual is considered a “pattern day trader.”
Once traders are identified as a pattern day trader, they must maintain a minimum balance of $25,000 in equity in their account to continue day trading. Many traders do not like such a restriction and work around it by trading with more than one brokerage firm.
For example, instead of triggering the pattern day trader identification by opening and closing four trades in four days with Broker A, the trader can do two of the trades with Broker A and the other two with Broker B.
- Day traders are individuals who execute and complete all of their trades before the close of the trading day.
- The goal of day trading is to capitalize on supply and demand inefficiencies, which generate intraday market price action.
- There are a variety of trading strategies a day trader may employ, including scalping, news-based trading, and high-frequency trading.
Succeeding as a Day Trader
To be successful and profitable, day traders need to be knowledgeable about the assets they trade and possess a wealth of trading experience. They must incorporate up-to-the-minute analytics and news feeds from a variety of sources to ensure that their market analysis is based on the latest reliable information.
Many day traders employ technical analysis to generate signals of favorable trading probabilities. Others rely primarily on fundamental analysis and look to “trade the news” (open and close market positions based on relevant news releases). Some – typically, only those with a lot of trading experience – simply rely on instinct to determine which plays to make.
Day Trading Strategies
Day traders may employ a wide variety of basic strategic trading approaches, including:
The scalping strategy involves the day trader looking to make a profit from small price changes – trades are executed quickly, often being opened and closed within just a few minutes, sometimes even seconds.
For the strategy to be effective, a day trader must have a precise entry and exit strategy and must be careful to execute trades with precision because when looking to just make a small profit, every penny of the bid and ask spread – both entering a trade and subsequently exiting it – counts. Scalpers should act quickly before a window of opportunity closes.
Example: Based on a technical chart pattern, the trader believes that Stock A, priced at $14.50, is due for at least a small rally. He buys the stock, then sells it when the price reaches $15 just a couple of minutes later, for a 50-cent per-share profit.
2. News-Based Trading
The news-based trading strategy involves the use of accurate, timely information from various news sources regarding events that are likely to affect the price movement of assets; events like acquisitions or earnings announcements cause increased volatility the day trader can benefit from.
Example: Several reliable news sources report that Company A is about to announce its intention to acquire Company B. The trader buys stock in Company B. When the announcement comes, Company B’s stock price rises sharply. The trader cashes out for a quick profit.
3. High-Frequency Trading (HFT)
As the name suggests, the high-frequency-trading strategy involves the execution of a large number of orders transacted quickly through the use of an automated trading platform; the platforms utilize algorithms that can quickly analyze market trends and shifts and send out baskets of stock orders with bid-ask spreads that benefit the trader.
High-frequency traders are often arbitrage traders looking to profit from small price discrepancies in the same asset as traded on different exchanges.
Advantages and Disadvantages of Day Trading
As with any approach to investing, day trading carries both advantages and disadvantages. Investors need to consider the relative pros and cons before deciding whether or not to embark on a career as a day trader.
Advantage #1 – No risks associated with holding a position overnight. Since day traders close out their trading positions before the close of each trading day, they don’t need to worry about some overnight news event causing the market to open substantially lower or higher the next trading day – something that can cost them money in a position held overnight.
Corresponding Disadvantage #1 – Sometimes, those overnight events that cause gaps up or down the following trading day are very profitable for traders holding positions overnight. Day traders will never reap such benefits, though.
Advantage #2 – Returns on investment compound more quickly (assuming your day trading is profitable). You may be able to take the profits from the previous trading day to trade a larger position the following day and generate even greater profits.
Corresponding Disadvantage #2 – More frequent trading means higher trading costs in the form of commissions and fees. Paying all those extra charges may cut into your profitability significantly.
Advantage #3 – It may require overall less time to generate substantial profits. Some day traders only make one or two trades a day, and generally, make them early in the day. They’re finished working at their trading job by 10:00 a.m.
Corresponding Disadvantage #3 – It may require more time than you have available for trading. Obviously, day traders must have the ability to pay attention to market action for at least part of the day. If not outright impossible, it may be very difficult for someone working a full-time job from 8:00 a.m. to 5:00 p.m.
The Debate Over Day Trading – Risk vs. Reward
Day trading is considered “the road to riches,” particularly after experiencing a surge in popularity in the 1980s. It does, indeed, offer traders the opportunity to generate much higher investment returns than what’s possible with a more traditional “buy and hold” strategy.
However, there are substantial risks involved. An ineffective strategy – or one that is poorly executed – will leave a trader around break even, at best. At worst, the trader could lose substantial amounts of money very quickly.
Depending on the strategy the trader uses, which is usually based on his or her risk tolerance, knowledge, and experience, earnings from day trading may be relatively small and require the trader to exercise patience and persistence to build up any sizeable profit.
In short, the reality of day trading is a far cry from the portrait painted by a variety of day trading programs being marketed online that suggest that day trading is an easy way for everyday individuals to get rich quick.
Day trading is inherently risky and requires forethought, careful planning, and solid entry and exit strategies. Those who are successful are often traders who thrive on making fast trades.
Most economists and financial advisors suggest that longer-term, more passive trading strategies offer more room and latitude to generate sizeable profits for traders.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: