When most people think about “trading in the stock market” there’s a good chance they’re thinking about day trading. This perception of trading tends to get a bit of Hollywood glamour since we look at it as a way to make money quickly by hitting on the right trade at the perfect time.
But is it really as exciting and profitable as all that? Learning how to properly day trade takes work, discipline, and an iron stomach. Here’s what you need to know if you want to take the plunge.
What is day trading?
In his book, “Day Trading 101,” long-time trader David Borman made the point that most people are involved with long-term investing. They put money into their 401(k) accounts and wait for the money to grow over time, hopefully resulting in wealth at a later date.
He also made a distinction between “regular” stock trading and day trading. With stock trading, explained Borman, the goal is to make a profit off their moves. However, even with stock trading for profit, it’s possible to hold a position for months — or even years — until the trade reaches the desired level of profitability.
How day trading works is different from both of these forms of investing. The idea with day trading is to start each day completely in cash. Then, while the markets are open, you buy and sell with the hope that you can make a profit on each trade. All your positions should be sold by the end of the day, and you should, again, have nothing but cash in your account.
“Although the profit on each trade is often relatively small, the volume of their trades allow day traders to book huge profits on average-sized accounts over the year,” Borman said. “As the profits come in, the trader’s account grows in value, allowing larger trades.”
Risks of day trading
Jason Brown, an investing coach with more than 10 years of trading experience, pointed out that the biggest risk of day trading is the risk of loss. Most day traders operate using leverage — they borrow in order to make their trades. So, when a loss is realized, the leverage magnifies it.
“I once lost $75,000 in 24 hours on a trade that went against me,” said Brown. “For many people, that’s a huge deal. I had to get in there the next day and I made almost half of it back.”
It can also be difficult to deal with the emotions involved with day trading. “It doesn’t affect you as much to lose thousands of dollars at once after a while, but in the end it’s hard to have the stomach for it,” Brown said.
Another downside, according to Brown, is the fact that you have to sit there all day, every day. To be successful, you’re chaining yourself to the desk the whole time the markets are open. And, in the end, you might not see better results than if you’d just held on to something for a couple weeks or months.
“Sometimes, I’d see the direction of a trade and realize that if I waited a week or a month, I’d have seen a bigger movement,” Brown said. “I was there every day, trying to make five dollars, but I could have made 10 dollars holding something for a week.”
In the end, the risk of loss, small daily profits, the emotional rollercoaster, and being stuck at a desk weren’t worth it to Brown, so he quit day trading to focus on other types of investing.
Costs of day trading
To answer the question, “Is day trading worth it?” you first need to understand the cost. For the most part, you’re going to pay a per-trade fee. So, each time you make a trade, it could cost between $4.95 and $6.95 (or more), depending on what the online broker charges. If you make 20 trades per day, you can see how the costs could add up — with even the cheapest broker, you’re still looking at close to $100 per day in trading fees.
One way to reduce the cost of day trading is to look for brokers that offer discounts for active traders. Another way to reduce the cost is to use a broker like Interactive Brokers, which caters to day trading and charges about $1.00 for every hundred shares you trade.
However, realize that a broker that caters to day trading may not offer extensive research and education tools. Instead, you’ll be able to program your own shortcuts and even use algorithmic trading. For some beginners, it can make sense to use a more expensive broker and make fewer trades to limit costs until you have a good grasp of what you’re doing. After some practice, switching to a cheaper broker to make a greater volume of trades can potentially increase overall profitability.
If you’ve been designated a “pattern day trader” by your broker, you’ll also have to meet a threshold of having $25,000 equity in your account if you want to trade that day. A “pattern day trader” is a margin customer that day trades four or more times in any period of five business days, provided the number of day trades amount to more than six percent of the customer’s trading activity for that time period.
Don’t forget, too, that you’ll have to pay interest when you trade on margin. So that will cost you extra if you borrow to make your trades.
Rewards of day trading
When done right, day trading can be extremely profitable. Brown said that he made more than $100,000 in profits one year. However, it requires discipline to get to that point, and the learning curve (and losses) can be steep before you get to that point.
Plus, once you get going, day trading really does offer a thrill. When you make a good trade, said Brown, it’s a great feeling. On top of that, there’s something satisfying about working out the puzzle, trading with your gut and being victorious.
“For long-term investing, there’s not a lot of genius involved,” Brown explained. “You invest in an index fund and your performance is based on the market, not how well you pick stocks or execute trades.”
Popular markets to day trade
“Stocks and futures have always been very popular among day traders,” said Gary Norden, the principal of boutique financial markets consultancy Organic Financial Group. He’s a former pit trader with more than 30 years of experience in the markets. “In recent years, though, Forex markets have probably been the biggest growth area.”
Day traders can execute trades involving the movements of commodity and stock futures, as well as currencies in the forex markets, in addition to trading in the stock market. Norden prefers futures markets for day trading, though. He likes the transparency of the futures market as compared to options and forex, and finds futures a little more flexible in terms of trading than using the stock market directly.
However, it’s often a good idea to start trading in the types of markets you understand better. It can give you a chance to practice in an area you know, and have a better chance of success with before you begin allocating money to a new asset class.
What you need to get started day trading
It doesn’t require a lot of fancy equipment to begin day trading. If you have a good internet connection and a computer, you can get started. Some day traders do like to have at least two computer monitors, though, to better identify and manage opportunities.
When looking for a broker, it’s important to find someone who offers the tools you need. If you’re trading stocks, a broker with a good screening tool is vital, said Brown. You also need a trading platform that’s fast, since getting in and out of trades at the right time is one of the most important aspects of day trading. Also, consider the fees imposed and your frequency of trading. If you’re stuck paying $4.95 for each trade, it’s going to add up fast.
Find a broker that suits your style and offers you access to the markets you’re most interested in. You don’t need a lot of research and education tools from the broker to be successful, Norden said, but it does help if the broker or platform offers a news stream of current events so you can see potential impacts in real time. Research tools aren’t as important as the ability to trade immediately and find suitable trades as quickly as possible.
More important to getting started is your mindset. “Discipline is essential if you are to become a good day trader,” said Norden. “You must only trade when you have an edge and must cut losses very quickly.”
Because of the ability to trade with leverage and since you can start by making small profits, you don’t need a lot of capital to get started. A couple thousand dollars is usually enough to get going, although you’ll have to be patient with the growth of your money in the beginning.
Finally, you need a risk-taking mentality. It’s vital to be comfortable with the idea that you could lose a large amount of money in a short amount of time. You’ll also need to make sure that you’re only day trading with money you can afford to lose, or that you can tie up as you try to recover losses.
Day trading can be one potentially lucrative way to make money in the financial markets. However, it takes consistent effort and the ability to handle losses as well as gains. Before you begin day trading, figure out whether it’s the right fit for you. Consider your financial and emotional risk tolerance and make sure you’re prepared for the risks as well as the potential rewards.