On the surface, the allure of day trading is undeniable: Earning your living executing stock 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.
Still interested? 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 a stock over a short timeframe, typically just a day. The goal is to earn a tiny profit on each trade and then compound those gains over time.
With the rise of the online stock broker and cheap trades, day trading became a viable (albeit very risky) way for retail investors to trade stocks. Traders look to add up daily gains, turning 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.
How day trading works
Volatility is the name of the day-trading game. Day traders rely heavily on a stock’s or market’s 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.
Why is day trading so difficult?
There are two major reasons:
- Retail day traders are fighting against professionals who devote their careers to it. 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 also particularly 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.
Also worth noting: If you do become a successful day trader, you’ll have to pay taxes on these net short-term gains at your marginal tax rate, currently as high as 39.6%. The IRS defines net short-term gains as those from any investment you hold for one year or less. You do, 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, 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.
Top research; two powerful trade platforms; educational content
commission-free trades + up to $600 with qualifying deposit
on TD Ameritrade's secure website
Discounts for frequent traders; strong platform
on Interactive Brokers's secure website
And if day trading isn’t for you? Then you can do what many intelligent investors do: engage in long-term, buy-and-hold investing in a well-diversified stock or fund portfolio. Add cash to the account regularly and let the power of growing businesses lead your portfolio to long-term gains. (Read more about other stock-trading strategies.)
No, it’s not as exciting as day trading. But it’s far more likely to grow your wealth over the long term.
» Looking for your first online broker? See our analysis of the best online stock brokers for beginners