On a similar note...
On a similar note...
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The allure of day trading stocks is undeniable: Earning your living executing trades from the comfort of your home seems far more exciting than most 9-to-5 gigs. Trouble is, careless or inexperienced day traders can wreck their portfolios in the blink of an eye.
But if you're still interested in this strategy, read on to learn how day trading works and the ways you can help minimize its risks.
What is day trading?
Day trading is the practice of buying and selling stocks in a short time frame, typically a day. The goal is to earn a tiny profit on each trade and then compound those gains over time.
With the rise of online stock brokers like Robinhood and cheap or free trades, day trading became a viable (albeit very risky) way for retail investors to turn a few days’ worth of quick wins into a substantial bankroll.
Successful day traders treat it like a full-time job, not merely hasty trading done between business meetings or at lunch.”
In practice, however, retail investors have a hard time making money through day trading. A 2010 study by Brad Barber at the University of California, Davis, suggests that just 1% of day traders consistently earn money. The study examined trades over a 14-year period, from 1992 to 2006.
The very small number who do make money consistently devote their days to the practice, and it becomes a full-time job, not merely hasty trading done between business meetings or at lunch.
If this all sounds like a bit more risk than you’re willing to take on, you can do what many investors do: engage in long-term, buy-and-hold investing in a well-diversified portfolio containing low-cost index funds and ETFs. Make regular investments into the account and let the power of growing businesses lead your portfolio to long-term gains. (Read more about other stock-trading strategies.)
It's not as exciting as day trading, but it's far more likely to grow your wealth over the long term. However, if day trading is something you must try, learn as much as you can about the strategy first.
How day trading works
Volatility is the name of the day-trading game. Day traders rely heavily on stock or market fluctuations to earn their profits. They like stocks that bounce around a lot throughout the day, whatever the cause: a good or bad earnings report, positive or negative news, or just general market sentiment. They also like highly liquid stocks, ones that allow them to move in and out of a position without much affecting the stock’s price.
Day traders might buy a stock if it’s moving higher or short-sell it if it’s moving lower, trying to profit on a stock’s fall. They might trade the same stock many times in a day, buying it one time and then short-selling it the next, taking advantage of changing sentiment. Whichever strategy they use, they’re looking for a stock to move.
Buying on margin
To increase profits, many traders use borrowed money to make their trades, a practice known as “buying on margin.” With a margin account, you can use the securities you already own as leverage to borrow up to 50% of the value of the security you’re going to buy. Leveraging like this can augment profits beyond what you could achieve with your own cash, but it doesn’t come without significant risks — your losses will be amplified, too.
Here’s how it works. If you wanted to buy $20,000 worth of a stock, you could purchase $10,000 worth of shares, and borrow the other $10,000 from your brokerage firm. If you bought the stock at $10 per share and it later increased 20% to $12 per share (and you sold at that price), you would have $24,000. After paying back the $10,000 loan to the brokerage firm, you’re left with $14,000 — a 40% increase over the $10,000 you invested with your own money. Without the borrowed money, your return would have only been 20%.
But what if the stock price had fallen 20%? Same rules apply, but the other way around. If you sold at $8 per share, you would only have $16,000. After paying back the $10,000, you’re left with $6,000 — a 40% loss from your original investment.
One thing to note: The examples don’t include the interest you’ll pay on the margin loan, but this should also be a consideration.
Day trading rules and risks
The Securities and Exchange Commission makes it clear: Day trading is not investing. Investing involves a fundamental analysis of stocks to determine good long-term prospects. Day traders, on the other hand, use expensive, state-of-the-art technology and technical analysis to spot intraday trends they may be able to capitalize on. The Financial Industry Regulatory Authority has written rules to regulate this fast-moving practice and to educate investors about the potential for significant losses.
Pattern day trader
If you execute four or more trades within a five-business-day period — and those trades account for more than 6% of total trades in your margin account in that same period — you’re considered a pattern day trader. As a PDT, you’ll be required to maintain $25,000 in equity in your day trading account, which must be in the account before you start trading. If your balance falls below this threshold, you won’t be allowed to trade until the cash and securities in the account are back up above $25,000.
In addition to the $25,000 minimum, you’ll need to meet what’s known as the maintenance margin requirement. Under the rules currently set by FINRA, the current maintenance margin requirement is 25%, meaning after any purchase, you must maintain 25% equity in your account. So if the total value of securities in your account were $50,000 and you had a $20,000 margin loan balance, your equity would be $30,000, or 60%. In this instance, you would be operating within FINRA rules.
If that percentage of equity were to fall below 25%, your brokerage may hit you with a margin call, in which you would have to fund your account with cash or security purchases to bring your equity back up to 25%. If you don’t, your brokerage may sell your securities, without consulting you, to maintain the maintenance margin requirement.
» Concerned about day trading risks? Read our guide on how to day trade safely
Swing trading vs. trend trading vs. buy and hold
So how does day trading compare with other forms of investing, such as swing trading, trend trading and buy-and-hold investing?
While a true day trader will close out all positions at the end of each trading day, a swing trader may hold for days or even weeks before selling. With more time for a stock’s price to grow, there is more opportunity to profit in swing trading, and risk can be managed through selling techniques, such as stop-loss and stop-limit orders. (Learn more about how to sell stock.)
With the right selling strategy, swing trading can have lower downside risk than day trading, but the risk of finding stocks set to rise still remains. For every stock you’re watching, there are hundreds of others you’re missing, which could lead you to underperform the market as a whole. In this instance, you could have done better investing in a broad index fund or ETF.
Short-term trend trading involves studying a stock’s past price movements to predict future behavior. Trend trading typically occurs over a matter of months, though trends can exist far beyond this time frame. Trends are identified as the time between a stock’s highs and lows of a given period. Trends can also run sideways, with little rise or fall in the stock price over a given period.
By studying past movements, trend traders seek to identify which direction the price is currently headed, buy stocks as early in an upward trend as possible, and hold for as long as they can before selling, based on when they believe the stock will hit its peak.
On this longer timeline, trend traders can also look at broader economic trends and business cycles to determine when to buy and sell, something typically not available to shorter-term day traders and swing traders.
Buy and hold
The buy-and-hold strategy, which is widely accepted as one of the best strategies for building long-term wealth, is exactly as it sounds: buy a security and hold it for years or even decades, no matter what happens to the market.
The goal with this passive investing strategy is to ride out short-term losses with the understanding that over time, an investment’s price will recover and continue to grow. This is the base for most retirement accounts, such as 401(k)s and IRAs, and is best used when your investment timeline is longer than five years.
Why is day trading harder than passive investing?
There are two major reasons:
Retail day traders are competing with professionals. Pros know the tricks and traps. They have expensive trading technology, data subscriptions and personal connections. They’re perfectly outfitted to succeed, and even then they often fail. Among these pros are high-frequency traders, who are looking to skim pennies or fractions of pennies — the day trader’s profit — off every trade. It’s a crowded field, and the pros love to have inexperienced investors join the fray. That helps them profit.
Retail investors are prone to psychological biases that make day trading difficult. They tend to sell winners too early and hold losers too long, what some call “picking the flowers and watering the weeds.” That’s easy to do when you get a shot of adrenaline for closing out a profitable trade. Investors engage in myopic loss aversion, which renders them too afraid to buy when a stock declines because they fear it might fall further.
» Read more: Don't be your own worst enemy when investing
Also worth noting: If you do become a successful day trader, you’ll have to pay taxes on short-term gains at your marginal tax rate. The IRS defines net short-term gains as those from any investment you hold for one year or less. You may, however, get to offset the gains with trading losses.
How do I start day trading?
The first step is to ask yourself: Am I truly cut out for this? Day trading requires intense focus and is not for the faint of heart. It's also not something you want to risk your retirement savings on.
Consider opening a practice account at a suitable brokerage before committing any real money to day trading.”
One critical tip: Open a practice account at a suitable brokerage and give it a go before committing any real money to day trading. Many brokerage accounts offer practice modes or stock market simulators, in which you can make hypothetical trades and observe the results.
» Get started: NerdWallet's picks for the best brokerages for day trading
On the topic of brokerage accounts, you will also want to make sure you have a suitable one before you begin day trading. High transaction costs can significantly erode the gains from successful trades, and the research resources some brokers offer can be invaluable to day traders.
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