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.
What is Day Trading?
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.
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How to Become a Day Trader?
There are several important requirements to become a day trader. Here are some of the key points to keep in mind:
- Make sure that you are adequately capitalized. To actively day trade stocks in the US, it is required that you maintain a balance of $25,000 in your trading account.
- Get the appropriate hardware. A computer with high-speed RAM (Random Access Memory) and a fast processor (CPU) is optimal. Additional monitors for charts and other data may be helpful.
- Make sure you have a reliable, high-speed internet connection. Speed is the name of the game when it comes to day trading.
- Select a good broker. Look for a reputable broker that provides fast, reliable execution, low fees and good customer service.
- Direct Market Access (DMA). If you are planning to day trade stocks, consider working with a broker that provides Direct Market Access, which enables faster order execution.
- Educate yourself. Day Trading for Dummies by Ann C. Logue is a good reference for beginners and Trading in the Zone by Mark Douglas is a classic book on trading psychology. Technical Analysis of the Financial Markets by John Murphy is considered by many to be the most authoritative text on the subject.
- Choose a strategy. Find a trading strategy that suits you and test it using a demo account. Most brokers offer free demo accounts that allow you to practice trading in live market conditions without risking any real money. Software platforms such as TradeStation and MetaTrader allow traders to backtest their strategies using historical data, showing them how they would have performed during a given period.
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Day Trading Strategies
Here are some of the most popular types of trading strategies that are used in day trading:
- Trend trading strategies. These aim to profit from an asset continuing to move in the direction of a prevailing trend. An example of a trend trading strategy is a breakout strategy, where a trader looks for price to ‘break out’ above or below a key technical level and continue in the direction of the broader trend.
- Mean reversion strategies. This type of strategy aims to capitalize on the idea that after an extreme price move, prices tend to revert back to average levels. Bollinger Bands® are an example of an indicator that is used as part of a mean reversion trading strategy.
- News trading strategies. An example of a news trading strategy is looking at how economic data came out in relation to analyst expectations and making a trading decision based on that. For example, if US employment data beats analyst expectations, a day trader might decide to buy or the (SPY).
- Price action strategies. This method of trading uses pure price movement on a chart with minimal or no use of indicators. Patterns such as ‘pin bars’ and ‘inside bars’ give clues on whether price will continue in the direction of the trend or potentially reverse.
- Gap trading strategies. Gaps are spaces on a chart where the price of a financial instrument jumps higher or falls lower, with little or no trading in between. Gaps often take place outside regular trading hours. An example of a basic gap trading strategy is to find a stock that has gapped higher or lower, identify the range during the first hour of trading and then either buy when the price rises above the top of the range or sell when the price falls below the bottom of the range.
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.
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Is Day Trading Worth it?
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:
- Day Trading for a Living? In this study, researchers tracked day traders in the Brazilian equity futures market. They found that 97% of traders who persisted for over 300 days lost money.
- The cross-section of speculator skill: Evidence from day trading This long-term study of stock traders in Taiwan found that less than 1% of day traders were able to predictably and reliably earn positive abnormal returns net of fees.
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.
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Is Day Trading Legal?
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.
What are the Rules of Day Trading?
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.
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How Much Money Do You Need For Day Trading
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.
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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.
Hardware
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:
- Processor Speed. The Central Processing Unit (CPU) is the main driver of speed in a computer. Trading software is highly resource-intensive, so it’s important to have a processor that is up to the task. A 2.8 GHz quad-core processor is recommended as a minimum.
- Memory. RAM (Random Access Memory) is used by applications to store and access data on a short-term basis and plays an important part in the performance of your computer. 16 GB of RAM is a good starting point for day traders.
- Multiple Monitors. Multiple monitors enable day traders to operate the fastest, allowing them to take in the most data at a glance and rely on minimal clicks and keystrokes. Multi-monitor graphics cards allow traders to create an optimal screen setup.
- Extra Security. In addition to antivirus software, having a battery backup and surge protector is worthwhile for serious day traders.
Direct Market Access
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
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.
Screening Software
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:
- To find high volatility and high volume stocks (the stocks ‘in play’ for the day).
- To find stocks that recently reported earnings.
- To find stocks that are gapping higher or lower in the premarket with above average volume.
- To find stocks breaking out to new highs or lows with high volume.
- To find stocks that have formed specific chart patterns. For example, some screeners have the capability of screening for Japanese Candlestick patterns like Shooting Stars or Hammers.
Charting
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
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
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.
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Cash vs. Margin Account
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:
- The Pattern Day Trader rule does not apply. It is possible to day trade with a balance of less than $25,000.
- However, after making a transaction in a cash account, the cash used must go through a settlement period, which is within two business days after the transaction date.
- Cash account holders have no risk of receiving a margin call – when a broker asks that you deposit additional funds into your account to cover a losing position.
- It is not possible to short sell securities in a cash account. Short selling requires a margin account because you are selling something you do not own. When you short sell stocks, you are borrowing the securities from your broker.
Key features of a margin account:
- Traders using a margin account are subject to the Pattern Day Trader (PDT) rule, which states that traders must have at least $25,000 of cash to make more than three day trades within five business days.
- The standard level of margin offered by retail brokers is 4-to-1 intraday margin and 2-to-1 overnight margin. This means that with a $50,000 account balance, you could take on up to $200,000 worth of market positions intraday and up to $100,000 worth of market positions overnight.
- Trading from margin accounts can potentially amplify profits, but on the flip side there’s also a risk of greater loss.
- Having a margin account allows you to short sell securities, opening up a greater number of trading opportunities.
- With a margin account, you run the risk of receiving a margin call, which could result in liquidation of a market position. You might also be asked to deposit more funds in your account.
- Traders must pay interest on the margin used on any position held overnight. Margin interest rates vary by broker and are one of the few remaining ways retail brokers make money, now that $0 commissions are the norm.
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Additional Detail on Day Trading Strategies
- Momentum Trading Strategies. Momentum strategies are based on capitalizing on stocks that are making major moves for the day. Traders look for volatile stocks with relatively high volume and a catalyst such as earnings or breaking news. The goal is to enter trades in stocks experiencing short-term, fluid trends driven by momentum and then exit when the momentum fades.
- Strategies using Classic Chart Patterns. Day traders can benefit from using classic chart patterns such as Head and Shoulders (Tops and Bottoms), Double Tops/Bottoms and Bull/Bear Flags.
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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