What is Day Trading? | Day Trading 101 - MagnifyMoney

What Is Day Trading? Day Trading 101

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It may not have not been reviewed, commissioned or otherwise endorsed by any of our network partners or the Investment company.
How MagnifyMoney Gets Paid ?
Advertiser Disclosure

What is day trading? You can summarize it using Kenny Rogers’ classic lyric about poker from “The Gambler”: Know when to hold ‘em, know when to fold ‘em.

Day trading is buying (then “holding”) and selling (“folding”) stocks and other securities in a short window — often the same day — to profit from price movements. But like poker, day trading can be a risky endeavor that drains your bank account if you don’t have a strategy, know the rules and invest in some practice.

What is day trading and how does it work?

With both poker and day trading, you’re looking to profit from inefficiencies. In poker, those inefficiencies could be inexperienced players or the opportunity to call a small bet to win a big pot. As a day trader, price changes are your inefficiencies.

It seems simple enough — you buy a stock and watch the screen until the price increases, then hit the “sell” button. But let’s take a look at what you have to risk to win:

In action

Say you buy 100 shares of Big Gaming Company (BGC) at $8.40 per share when the market opens. If the price rises to $9.00 per share later that day, you’d sell all your shares at a profit of $0.60 per share ($60). That’s not a bad score for a few hours watching a screen.

Here’s another way to look at it: You just bet $840 to make $60. If day trading were Kenny Rogers’ poker game, would you have pushed $840 in chips into the pot to win a mere $60? (Please don’t tell us if you would have made that bet.)

With day trading, your goal isn’t necessarily huge wins from every trade. Instead, you’re looking for small gains that add up over time so you can pool those small wins together. Then, you can increase your stake in the market and buy larger positions that can lead to greater per-transaction profits.

Are there different types of day trading strategies?

Price volatility can stir-up emotions in even the most seasoned trader. Unfortunately, though, heightened emotions can lead to bad bets and regrets. That’s why having a strategy to guide how you buy and sell is so important.

A trading strategy, at its core, sets parameters that dictate when you buy, hold and sell instead of letting emotions run that process. Some of the most popular day trading strategies include:

Breakout trading

Breakout trading refers to trying to buy or sell securities when their price “breaks out” above or below a price the stock hasn’t recently. You would attempt to chase the breakout price by buying or selling aggressively before the stock crashes.

Pullback trading

With pullback trading, traders are on the lookout for securities with stable upward trends. So as soon as these stocks experience a price slip, you’d pounce and buy — hoping the price rebounds and resumes its upward trend.

Swing trading

Swing trading is more like days (plural) trading. You probably won’t liquidate positions at the end of each trading day; instead, you’ll hold positions for a couple of days or even longer. You’ll buy at a “support” position — a price where a security historically triggers a buying trend. You’ll then sell at a “resistance” position — a price peak that typically triggers a selling trend.

Trend trading

Trend trading is like chasing fashion trends — you want in as early as possible to make the most of your purchase. If you trend trade, you’ll look for indicators (political, environmental, economic) that would mean certain securities might gain or lose value. Then, you’ll buy a security on an upward or downward price trend, riding the trend in your chosen direction until indicators cause the price trend to change.

What about margin trading?

If you’re not satisfied with that $60 single-day profit in the example above, don’t worry — many day traders aren’t, either. That’s where margin accounts come into play.

With a margin account, your brokerage loans you money based on cash and other securities in your account it can use as collateral. Then, you’ll place trades using the loan proceeds, also called “buying on margin.” You’ll also pay interest on your margin loan, usually at rates lower than personal loans or credit card cash advances.

In action

Say you have a stock position valued at $5,000 in your brokerage account, but there’s a price dip and you want to buy $5,000 more of that stock. You can borrow $5,000 from your brokerage to make that buy by opening a margin account. Your existing $5,000 in stock becomes collateral for the loan.

If you bought 100 shares of stock at $50 per share and the price goes up to $60 per share, you could sell and pocket $1,000 after paying back the margin loan.

But if that stock goes down to $40 per share and you sell to cut your losses, you’ll owe your brokerage the original $5,000 loan plus an additional $1,000 to cover the $10 per share price drop.

Margin account requirements

Just as you couldn’t buy into a poker game for free, you’ll have to stake some cash to open a margin account because. Financial regulators and individual brokerages set different margin requirements.

  • Minimum deposit (minimum margin). To open a margin account, the Financial Industry Regulatory Authority (FINRA) requires you to deposit the lesser of either $2,000 or 100% of the purchase price of the securities you intend to buy on margin.
  • Maximum margin loan (initial margin). Regulation T of the Federal Reserve board limits margin loans to 50% of the intended security’s purchase price. Your broker might require a larger deposit.
  • Margin maintenance. Once you own securities in a margin account, FINRA requires that you maintain a minimum of 25% equity in the account at all times. However, your broker’s specific equity requirements might be higher — often 30 to 40% or more.

Margin account risks

By nature, day trading depends on rapid price fluctuations in the market to generate profit. When you’re buying on margin, however, fast-moving prices can wreak havoc in the blink of an eye.

  • Losses. When you transact in a cash account, you only stand to lose as much money as you have in the market. With margin accounts, you can lose more than you have invested.
  • Margin calls. When securities in your margin account lose value and your account equity drops below your broker’s maintenance requirement, your broker will issue a margin call — a demand to deposit cash or securities to bring your account equity up to required levels. You’ll generally have only two to four days to make this deposit.
  • Missing a margin call. If you can’t make the required deposit, your brokerage can sell other securities in your account to satisfy the call — and no, you don’t get any say in which securities they sell.

There’s no requirement that you use a margin account for day trading. It’s even advisable to stick with a cash account for trades. With a cash trading account, you can gain experience while limiting losses before buying securities with borrowed money.

Are there day trading rules?

If you have visions of becoming a day trader, you need to know about the FINRA pattern day trader label and the IRS’s wash sale rule. Both rules impact your cash requirements and profit potential.

Pattern day trader label

Day trading is about price and volume — and high volume trading could earn you FINRA’s “pattern day trader” label. If you repeatedly make four or more trades within five business days, that meets FINRA’s definition of a pattern day trader. If you’re labeled as such, according to either FINRA’s or your brokerage’s definition, you’ll be subject to different rules and regulations than less active investors.

As a pattern day trader, you’re required to conduct all trades in a margin account. You’ll also be required to keep a minimum of $25,000 in your account, which can be a combination of cash and securities. If your margin account balance drops below this threshold, you won’t be able to trade until you bring your equity level back up to $25,000.

Wash sale rule

Wash sale rules say you can’t deduct a trading loss on your taxes if you have both a gain and loss for that security (or a substantially similar one) within a 61-day window.

In action

Say you buy 100 shares of Super Cool Computer Company (SCCC) at $230 per share, but the price tanks to $190 that day, and you sell to cut your losses. After you sell, you buy 100 shares at the $190 price and hope the stock price rebounds by the end of the day to recoup some of your losses. Then you’ll write that pesky $4,000 loss off on your income taxes.

These transactions equate to a wash sale because you have both a loss and a gain for the same security within the 61-day window. You can’t deduct your $4,000 loss on your taxes, either. Even if you bought Moderately Cool Computer Company (MCCC) after selling SCCC, it’s likely still a wash sale because the two stocks are considered “substantially similar.”

Are there day trading risks?

Indeed. Beyond margin account risks, other risks are involved, such as:

  • Capital gains taxes. Since most day trading strategies are inherently short-term, you could be subject to short-term capital gains taxes on your profits — taxes assessed on securities held for one year or less. You may think you’ve made a profit, until these taxes wipe out your gains. You can strategize with a tax professional or use specific tax-reduction techniques to decrease your capital gains tax exposure.
  • Margin calls. Your brokerage might ask you to add money to your margin account if your securities lose value. If you can’t cover the call (make the required deposit), you could land in severe debt and rack up interest until you can.

Can you make money day trading?

While it used to be a practice left to financial professionals, day trading is more accessible than ever, with multiple online brokerages offering low account minimums and commission-free trades. Glassdoor even reports an attractive annual salary for day traders, too: $86,000 per year. But despite that number, it seems that only outliers make that kind of money.

  • Robinhood study. Academics concluded that “the top 0.5% of stocks bought by Robinhood users each day experience negative average returns of approximately 5% over the next month. More extreme herding events are followed by negative average returns of almost 20%.”
  • Brazilian study. Researchers studied roughly 1,600 day traders and found that “97% of all individuals who persisted [in day trading] for more than 300 days lost money. Only 1.1% earned more than the Brazilian minimum wage and only 0.5% earned more than the initial salary of a bank teller — all with great risk.”

Even the Securities and Exchange Commission has strong thoughts on day trading: “Unless you understand the risks you’re taking, and the economics and performance of leveraged investment strategies, such as trading on margin or using options or leveraged products, you should not engage in day trading.”

How do you start day trading?

If you remain undeterred at this point, take a cautious approach. Just like a first-time poker player (hopefully) wouldn’t take a seat at a table with a minimum $25,000 buy-in, you should aim to start small while you learn the ropes.

Paper trading can help you start without risking money. For example, you can buy and sell stocks by writing down the purchase and sale prices. Then, you’ll calculate profits or losses. You can also find online stock simulators, giving you a real buy-and-sell experience without opening a brokerage account.

When you’re ready to stake real money, look for an online brokerage with low account minimums and commission-free trades. Then, with your chosen strategy to guide your trades, set a goal for your first few sessions — perhaps to buy and sell your holdings within one to three hours. You can then evaluate how you made out profit-wise and decide the next steps to take.

The bottom line

Day trading is a high-risk game — much like poker — where you’re betting that your stock market timing skills will help you turn a profit. If you want to give day trading a go and see how the cards fall, you’ll likely be better off starting small. Like playing your first live poker game, make an investment you’re prepared to lose. If you make a bit of cash, be grateful and consider yourself lucky.

Frequently asked questions

Yes, it’s legal. While there are rules governing trading volume, margin calls and wash sales, there are no laws against day trading.
Like poker, there’s always the possibility to make money from day trading. And also like poker, your best opportunities to make money day trading will come with time, experience and a strategy to tell you when to cap your gains and cut losses.

It’s possible, but be cautious of people claiming to be ridiculously profitable day traders. Do plenty of research before taking advice from financial personalities who aren’t credentialed, including those who make money selling products with any words like “guarantee” in the sales pitch.

The “Find a Financial Advisor” links contained in this article will direct you to webpages devoted to MagnifyMoney Advisor (“MMA”). After completing a brief questionnaire, you will be matched with certain financial advisers who participate in MMA’s referral program, which may or may not include the investment advisers discussed.