Day Trading – A Risky Strategy That Can Pay Off

Infographic that explains what day trading is, what the requirements are, and how to start day trading.

In the past, day trading was limited to financial institutions, banks, and employees who worked as specialists for trading houses and brokerage firms. However, after the deregulation of trade commissions in 1975, the arrival of the internet, online brokers and trading platforms, and the occurrence of extreme volatility during the dot-com bubble, day trading has become extremely popular.

When people hear the term day trading, they think of people in front of a computer who trade stocks 24/7, become rich quickly, and can live the good life with a few clicks of a mouse. However, this is not the reality. Although day trading is defined as the buying and selling of financial assets to make a quick profit, very few day traders are successful, and most of them lose money in the long run!

Technology and the creation of online trading platform companies have made day trading stocks and other assets accessible to the masses. These days, almost anybody can start day trading. All you need is a computer, internet access, a brokerage account, and a little bit of money. 

Although day trading can be a lucrative career if done right, very few day traders are actually successful. The fact is that it is not something most people should be doing for fun or as a part-time job, as the risks are high. Day trading is typically based on technical analysis and therefore requires a high degree of self-discipline and objectivity. Without the proper knowledge and day trading experience, you are bound to lose money. Even the most seasoned professional traders sometimes experience substantial losses when the market takes an unexpected turn.  An important thing to remember before you decide to start day trading is that day traders are generally classified as speculators, not investors! 

This guide will explain the basics of day trading, some of its pros and cons, various day trading strategies, and risk/reward management. 

What Is Day Trading?

Day trading or intraday trading is a speculative trading style that involves buying and selling financial assets within the same trading day. It is most commonly used in stock markets and foreign exchanges (forex). Other popular day-traded assets are cryptocurrencies, options, various types of futures, and Exchange Traded Funds (ETFs)

Day traders typically exit all their positions before the market closes for that day. An example of such a trade would be if a trader opens a stock position at 11:00 AM and closes that position at 1:30 PM the same day. However, if the trader does not close that position until the next day, the trade will not be considered a day trade. Because profits are often only pennies to the dollar, traders often execute multiple trades in one day to capitalize on short-term price movements. In addition, they might use high amounts of leverage to further increase their buying power and potential profits. But, of course, using leverage adds to the risk factor. 

Day trading is often confused with swing trading. The main difference is that day traders close all their positions by the end of a single trading day, while swing traders keep their positions open for at least a couple of days and sometimes even several months. Another difference is that day traders typically only depend on technical analysis, whereas swing traders use a combination of technical and fundamental analysis.

Successful day traders generally have solid risk management skills, in-depth knowledge of technical analysis, and experience with various day trading strategies. In addition, they pay special attention to events that can cause short-term trading activity and price movements.

Required Asset Characteristics That Make Day Trading Possible and Profitable

Day trading is very different from traditional buy-and-hold investments. While returns from day trading largely depend on daily price movements and a trader’s experience, in-depth knowledge, and quick actions, returns from traditional investments are generally not significantly impacted by daily price movements.

There are several important asset characteristics that can significantly affect short-term market behavior and therefore impact the profitability potential of day trading. Here are the main factors that need to be present in the selected asset for day trading to be successful:

High liquidity – Liquidity refers to how quickly an asset such as a stock can be bought or sold without substantially changing the stock price. The higher the liquidity, the faster a stock can be traded. Generally, stocks from companies with a higher market capitalization are more liquid than those with a lower market cap. High liquidity is crucial for day traders. The higher the liquidity, the more trades can be executed. 

High trading volume – The trading volume of an asset refers to the number of shares or assets that changed hands during a given day on the stock exchange. It is a valuable measure to identify entry and exit points for day traders. An asset with a high trading volume means the demand for those shares or assets is high.

High volatility –The volatility of an asset is a measure of how quickly the price shifts. The level of volatility is an essential factor for day traders. When price action is high, day traders will have ample opportunity to make short-term profits. However, when volatility is low, there will be little opportunity for executing profitable trades. 

Financial Instruments and Services Needed to Make Day Trading Possible

Day trading requires access to some financial instruments and services. Here are some of these requirements:

Access to a Trading Desk or a direct access brokerage account- A Trading Desk is generally only accessible to day traders who work for large institutions or traders with a lot of capital. A Trading Desk is necessary for the instant execution of orders after a sudden price movement of an asset. The goal is to take action before the rest of the market can respond. Beating the competition means a more significant price differential and, therefore, a higher return. 

If you don’t have access to a Trading Desk, the next best thing is to select a reputable direct access broker. A direct access broker is a must if you want to get your trades executed quickly. Direct access brokers are specialized brokerage firms that allow orders to be sent directly to specific exchanges, ECNs, and market makers, bypassing all intermediaries. This means fast order execution which often leads to better prices and bigger profits. Examples of direct access brokers are Lightspeed and TD Ameritrade’s Thinkorswim platform. 

Please note that conventional brokers are not suitable for day traders because they use intermediaries and intermediaries significantly slow down order execution speed. Traditional brokers typically send customer orders through pre-agreed order flows to their market makers. This process is too “slow” for day trading because instant order execution is an absolute must for making profits. Conventional brokers cater to more traditional investors, such as self-directed investors and retail swing traders who do not need instant order execution. Trading apps like Robinhood or Webul do not offer direct market access and are not suitable for day trading.

Various news sources – It is essential for day traders to stay on top of the latest news events. As a trader, you need to pay attention to real-time breaking news and opinions on companies, assets, and financial markets that might result in a stock’s price moving up or down. The faster you act on this news and react to the volatility in the market, the more of an edge you have and the higher your potential profits will be. Some good news sources to follow are cnbc.comreuters.comseekingalpha.commoney.cc.com, and bloomberg.com.

Analytical software and stock scanners – Many day traders also rely on technical analysis and not just news sources to make their profits. As a result, most traders use expensive analytical and charting software, which helps them identify technical indicators such as flags and chart patterns. In addition, the software often allows backtesting strategies (simulation) to predict a potential strategy’s future performance. However, always remember that past performance does not guarantee future results.

Some software even interfaces directly with brokers to allow instant trade execution. Besides analytics, day traders need a stock scanner that constantly scans the market and streams real-time results to help them identify “stocks in play.” These are stocks that offer good trading opportunities.

Prerequisites to Be a Successful Day Trader

Most successful day traders who practice this speculative trading style are professionals and are highly knowledgeable about their trading activities. They work for large financial institutions, do not use their own money, and make high commissions. However, some successful day traders are individuals who use their own money and work for themselves. Here are some requirements that both types of successful traders have in common. 

Have In-depth knowledge and experience in the field

Those who start day trading without a proper understanding of the market basics stand a high risk of losing a lot of money. Experienced day traders possess in-depth knowledge of day trading basics, technical analysis, the assets traded, and what factors move the market. Chart reading is another skill successful day traders possess. Without a sound understanding of all these essential aspects of day trading, you will not be able to make the right decisions. 

Besides thorough knowledge, lots of experience in day trading will also improve your odds of coming out on top and making a profit. Whoever thinks that they can enter the day trading world and become rich quickly should think again. Even professional day traders lose money because the odds are stacked against them. 

Have a plan and focus on one trading strategy

The only way to be successful as a day trader is to make a plan and focus on a tested and proven profitable day trading strategy that can get you an edge in the market. Aspiring traders can either create their own trading strategy or adopt one of the strategies used by other successful traders. Most beginners are best served by picking a method proven to deliver profitable results. Once they master that strategy, they can customize the strategy to suit their needs and goals. 

Picking a day trading strategy is not easy as there are many different trading strategies to choose from. Start by studying actual trades and techniques by watching live trades, analyzing stock charts, trends, and reading financial analysis. Make sure you understand the process, methodology, and risk/return for each strategy. Then, decide which one you feel the most comfortable with and give you the best results. Then focus on refining the strategy until it delivers consistent profit and limits losses.

Know how to manage risk

Managing risk is another crucial step when preparing for day trading. Traders can minimize potential losses. Risk management tools like stop-loss and stop-limit strategies should be an essential part of any day trader’s overall plan. 

Infographic that explains what a stoll loss order is.

When day trading, it is recommended that you use stop-loss orders to limit losses in case a trade goes in the opposite direction of your expectation. A stop-loss order is an order to exit (close) a position when the security’s price hits your stop. You can set stops for both long and short positions. Stop-loss orders guarantee execution, but they do not guarantee a specific price.

For example, a trader buys a security (long position) at $50 because it is expected that its price will increase short term. However, to limit potential losses, the trader enters a stop order to sell at $45 in case the price goes down. Then, if the stock does go down and hits $45, the order gets triggered and sold at the next bid price. Please note that a stop-loss order can also be used when short selling, where the stop will trigger a buy order to cover the short position.

A limit order is an order to buy or sell a security at a specific price or a better price. Buy limit orders will only be executed at the limit price or lower, whereas a sell limit order will only be executed at the limit price or higher. For example, if you wanted to buy a stock for $20, you could set a limit order at $20, and the order would only be executed if and when the stock price reaches $20 or lower. If the security’s price does not reach the limit price, the order will not be executed.

Chart that shows the entry and exit points of a stop limit order for a long position.

A stop-limit order is a combination of a stop order and a limit order. Its intend is to limit losses or lock in profits. It is an order that initiates a limit order once a security reaches a stop price. Once the stop price is reached, the order will be executed at a specified price (or better). This gives traders control over when the order should get executed. There is no guarantee that it will reach the limit and that it will be executed, but it does guarantee a price.

For example, if the trader sets a stop-loss order at $45 with a limit of $42.50, the order gets triggered at $45 but only gets executed at $42.50 or better.

Have enough capital available

Traders should only use capital they can afford to lose. This will protect them from ruining their financial goals and will help them make rational decisions by taking emotions out of the trading process. Day traders generally need significant amounts of money to capitalize on short-term price movements. Especially very active traders, such as pattern day traders, need to have enough capital available to reach a required minimum equity balance.

After day trading became accessible to the masses, and after the tech bubble burst and many traders lost a lot of money, the Financial Industry Regulatory Authority (FINRA) implemented The Pattern Day Trading rule in 2001 to help reduce the high risk associated with day trading. This rule protects traders from extreme price movements and discourages manipulation within the markets.

The rule defines that a pattern day trader (PDT) is a trader who executes four or more trades within five consecutive trading days using the same margin account providing those trades account for more than 6% of total transactions in that trader’s margin account in those five days. The rule only applies to margin accounts and not to cash accounts.

PDTs are automatically flagged by their brokers and are subject to additional regulatory scrutiny and obligations to discourage investors from excessive trading.

For example, if you are designated as a pattern day trader, you must maintain a minimum of $25,000 in equity in your day trading margin account. Without that, you cannot start trading. If your balance falls below this threshold, a margin call is issued and you will not be allowed to trade until the equity balance is back up to the $25,000 limit.

Many traders will try to avoid getting designated as a pattern day trader to avoid account minimums and margin calls.

Follow strict discipline

A trading strategy that seems to be profitable can go wrong if it is not executed the right way. Many day traders tend to incur losses from their inability to execute trades according to their plan. This inability often stems from traders losing focus because of their fear, greed, or hope. Therefore, traders should focus on following logic and not emotion. Hence, it is impossible to achieve success without discipline. 

Day traders rely on market volatility to increase their profits. A stock that has high volatility and moves a lot is attractive to a trader. New earnings reports or company news might move a stock price up or down and create an opportunity for the trader to make a profit. 

Traders also like liquid stocks because liquid stocks allow them to change their positions during the trading day. For example, they might short sell a stock that they believe will drop in price during that trading day. If the stock price does drop after selling, the short seller buys it back later at a lower price and returns it to the lender. The difference between the selling price and the buying price is the trader’s profit.

Day Trading Strategies and Techniques

As mentioned before, day trading requires discipline and focus. Therefore, many traders select to use one specific type of strategy. However, there is a multitude of day trading strategies to select from. Furthermore, most of these trading strategies can be used for almost any time frame, not just for day trading. Here is a brief explanation of some of the most common trading strategies and techniques day traders use to make their profits. 

Trend Trading

This strategy aims at making profits by studying an asset’s short-term past price movements and direction to predict future movements. For example, when an asset’s price rises, traders can profit by buying that asset, hoping that the upward trend continues. In contrast, when an asset’s price has been falling, they can short sell it in the hope that the price keeps falling. Day traders use technical analysis to identify these trends.

Scalping

Scalping is a day trading strategy that focuses on buying and selling a single stock multiple times in the same trading day. This trading strategy aims to make numerous small profits that add up to a significant profit during one day. Scalping demands a robust exit strategy; otherwise, losses can counteract small gains. It is ideal for day trading as positions are often closed before the end of the trading day to prevent ruining the profit margins by overnight funding costs. 

Trading the News

In today’s world, trading based on news has become increasingly popular because global and local information is easily accessible at any time of day. As a result, news traders focus on news events that will cause short-term price movements. 

There are two types of news, recurring news and unexpected news. Scheduled news announcements include company earnings reports, interest rate announcements by the Federal Reserve, and economic reports such as Quarterly GDP numbers. These recurring news events are subject to market expectations, and when the news announces that the expectations are met or exceeded, the asset price will go up. Conversely, when the news is bad, the price will typically go down. 

Markets often react to unexpected news, with sudden, significant moves. This can significantly benefit day traders who take advantage of these news events by buying or selling an asset and making a quick profit of its short-term volatility.

Risk versus Reward

Day trading and the risks involved is one of the most controversial frequently discussed topics on Wallstreet. Stories of day traders who “got rich quickly” are as familiar as tales of scams and empty promises that left traders penniless. 

The truth is that day trading is a high-risk/high-reward trading style. Looking at the nature of the financial leverage often associated with day trading, it certainly involves significant risk. However, with that high risk also comes a high reward potential and possible quick returns. 

The three main rules to trading are:

  1. Avoid losses
  2. Preserve your capital
  3. Make a profit

It is essential to understand that most aspects of day trading cannot be controlled. For example, you cannot control the outcome of your next trade or the market direction. However, the only thing you can control is the amount of risk you are willing to take.

Therefore, a risk management strategy is as crucial as the actual trading strategy selected. A refined risk management strategy gives you the ability to bear losses without a significant impact on reaching your financial goals. In addition, successful day traders are typically aware of the potential risks and expected rewards before executing a trade. 

A day trader always aims to trade at a point where the potential reward outweighs the risk. The risk/reward ratio expresses how much you are willing to risk losing versus how much you can expect to profit from a trade. The lower the ratio, the better for day trading. Even traders that have a high-risk tolerance should only execute trades with a low risk/reward ratio. Typically, a risk/reward ratio of 1:3 or lower is considered a “good” ratio. This ratio suggests that a trader is willing to risk $1 for the prospect of earning $3.

How To Start Day Trading?

If, after careful consideration of the information provided in this article, you still feel that day trading is something you want to get involved in, here are the steps that should help you get started:

1. Acquire as much knowledge as possible

First, you have to acquire knowledge about the market and day trading products and strategies. There is an enormous amount to learn, and this will take some time. A solid understanding of day trading terminology, technical analysis, charting, chart patterns, and the various day trading strategies is a must. Furthermore, it is essential to understand how various industries respond to short term price movements and how to anticipate these fluctuations. Therefore, day traders often specialize in one specific industry so they can be experts and know all the ins and out of the industry.

A lot of the general trading information is available for free on one of the many online trading platforms. In addition, most of these platforms offer fee-based comprehensive day trading courses that include live chat rooms, mentor session access, customizable stock scanners, and day trading simulators. 

2. Develop a strategy and make a plan

Before you start trading, you should consider outlining what you want to achieve and be realistic about your expectations. This step will be very time-consuming. However, the knowledge gained in step one will be the basis for selecting the strategy that will meet your financial goals, fits your style, and has proven to be a successful strategy. 

Make sure you know everything there is to know about the strategy you select and how the financial instrument you plan to trade reacts in different scenarios. In addition, you need to make sure that the risk/reward ratio is appropriate for a beginning trader. Finally, it is essential to determine how and when you will enter and exit the market.

3. Practice without risking your money

As they say, “practice makes perfect.” So, before spending any real money and risking losing all your money in your first few trades, you should practice in a demo environment to develop and perfect your strategy. There are plenty of online platforms that offer demo accounts to enable you to buy and sell in real-time. The more you practice, the more experienced you will get. As a result, your decisions will become more rational, and it will be easier to stick to your plan when you start trading with real money. 

4. Set your goals  

Make sure that the goals you set are reasonable. Reasonable goals can help keep you motivated. The most important goal to follow is to stick with your plan and know when NOT to trade! 

Most beginners will set a daily, weekly, or monthly profit goal. This is probably not the best thing to do as we know that most day traders lose money, especially when you are a novice. If you do need to set a profit goal, make sure it is small. As a beginning trader, it is essential that you ease into it and learn from your mistakes.  You can slowly increase your goals as you gain more experience and become more successful. It might also be necessary to take a step back and slow down after a period with significant losses.

For some beginners, the ultimate goal is to quit their job and make a living off of day trading. But, as we know, this goal will only be reached by very few. So, until then, make sure you understand and quantify what your limits are. 

5. Set your limits

Limits come in the form of budget and time. 

Especially at the beginning, you need to set a realistic limit on the money you are willing to spend/risk on day trading. Planning to use money that you cannot afford to lose is not a good idea. Remember, day trading is speculative, and nothing can protect you from an unforeseen event resulting in a market crash and high losses.

Another reason to set a budget is that a small win might make you overconfident and result in decisions that will end in considerable losses.

So, first, it is crucial to set a total budget and stick to it. Furthermore, your total budget should only include money you can afford to lose. Second, and equally important, is deciding how much you allow yourself to risk/lose in a single trade. As mentioned before, the only thing that traders can control is their risk. A common rule many day traders follow, even professional ones, is the 1% rule. This rule limits the risk on any single trade to 1% of a trader’s total account value. The rule’s goal is to avoid significant losses on single trades and allow you to stay in the game for a more extended period.

For example, let’s say that your total trading budget is $10,000, and you follow the 1% rule. This does not mean that you can only buy $100 (1% of $10,000) worth of stock. You can use all your capital if you want. However, you need to apply a risk management strategy to prevent losses of more than 1% on any single trade. For example, applying the 1% rule can mean trading significant positions with stop-loss orders very close to the entry price or small positions with far-away stop-loss orders.

As for time limits, you need to decide how much time you will spend on day trading and stick to that. Your day trading plan should not interfere with your regular job. Furthermore, make sure that you set aside full trading days for your trading endeavor. Otherwise, you will run the risk of not being able to close all the positions you opened in one day.  

6. Open a direct access brokerage account

The final step is one of the most important decisions you have to make as a day trader. You will have to select a broker that best meets your needs. Of course, this requires some research. Your success as a day trader is partially based on the broker you select. The most important factors to consider when evaluating online brokerages are trade execution, commissions, and fees. 

First, pick a broker that specializes in the financial instrument you are planning to trade. For example, some specialize in forex, while others specialize in stocks. Second, the trade execution speed is crucial as a couple of seconds can make the difference between catching or missing a breakout. Therefore, you should only consider brokers who provide direct market access and do not use intermediaries. 

Another essential factor to consider when selecting a broker is their commission structure and their fees. Nothing can reduce your profits faster than high commissions and administrative fees. So check the various brokers’ per-trade and per-share commission structures and decide what will be best for you. These days, there are even platforms that offer commission-free trading, which can reduce your costs and increase your profits.

Other broker features to consider should include minimum account balance requirements, charting and trading tools offered, and other services available with the account.

7. Open the first position

Finally, you are ready to start trading. When you are confident about your trading plan, you can go ahead and make your first move. You can enter both short and long positions in a single day. If you believe the market will rise, you choose to buy the asset; if you think it will decline, you may decide to sell it. 

It is essential to continuously monitor the market for events and news that could influence the prices of your assets. Maintaining a log of all the positions you have opened and closed in a day is a good idea. This way, at the end of the day, you have a good overview of all your trades and you can quickly identify the trades that still need to be closed. 

Day Trading Is Not for Everyone

As mentioned before, most day traders lose money, and day trading is not for everyone. However, for some, day trading can turn out to be a lucrative career, although the road to success is long and challenging. First, you need to acquire knowledge of the trading world and get an in-depth understanding of your financial goals, risk tolerance, and capital required before proceeding. 

Furthermore, day trading requires a lot of practice and dedication. The process of perfecting your strategy, limiting your risk, and maximizing your profits is time-consuming and difficult. Most successful day traders are professionals. Doing it as a part-time business is very risky and not recommended.

If you are a casual investor entering the market to make a quick profit or just want to play around, day trading is probably not for you. The biggest reason to be extra cautious with day trading is that you can instantly lose vast sums of money with just one wrong decision. Without proper training, a well-thought-out plan, a proven day trading strategy, and a solid risk/reward strategy, you can easily fall into the trap of rushing for big profits. You might even decide to borrow money for a trading opportunity, which makes day trading even riskier. 

So, if you are excited about the thrill of day trading and are eager to start, you need to start small. Focus on a couple of assets and ensure you limit your losses rather than risking a lot of money at once. Going head-first will only complicate things and bring huge losses. It is also essential to keep your emotions out of your trading decisions. The better you can stick to your plan, the more successful you will be as a day trader. 

Conclusion

Day trading is a controversial, speculative trading strategy. Because this strategy requires a lot of knowledge and experience, many potential traders have fallen victim to scams that promise them the get-rich-quick story. However, instead, they lose most of their money. 

This trading style is not for everyone. Still, with the proper knowledge, experience, discipline, and risk/reward strategy in place, day trading has the potential to bring in significant returns in a short period. 

Before deciding whether day trading is for you, please remember that most traders lose money and that the odds are not in your favor. Furthermore, you need to understand that you will be competing with professional day traders who will have technological advantages. If you do understand the risks involved and still want to become a day trader, you have to make sure that you follow your plan and keep your emotions out of your trading decisions. Then, maybe, with a lot of practice, experience, and continuous performance evaluation, you might just beat the odds. 

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.