What Day Trading Is and Why It’s Risky

Investing, Investing Strategy
day-trading-risks-story

A few lucky people do win the lottery, but odds are it won’t be you. That’s also how it is with 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 a handful of days. It almost sounds like something from a George Clooney heist film. The problem for day traders, though, is that they’re usually the ones on the losing end.

Day trading may be the fastest and most glamorous way for retail — or nonprofessional — investors to wreck their portfolio and retirement.

The advent of day trading

With the rise of the online stock broker and cheap trades, day trading became a viable, if inadvisable, 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.

That’s the theory, anyway.

In practice, retail investors have a hard time making money through day trading. Sure, they guess right from time to time, but the vast majority lose money. 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.

Gambling in disguise

Day trading is the epitome of short-term investing, and that kind of investing is a zero-sum game. In other words, your loss is another investor’s gain and vice versa. So for most investors, day trading is really gambling in disguise, trying to beat other investors as they’re trying to beat you, with the house — the brokerage — taking a piece of the action in the form of commissions.

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. Even if you don’t hit that top bracket, the government will still take a sizable chunk of your earnings, with lower rates ranging from 10% to 35%. You do, however, get to offset the gains with trading losses.

Popular day-trading strategies

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. (Here’s the lowdown on short-selling.) 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.

Here are some common day-trading strategies:

Swing, or range, tradingTraders find a stock that tends to bounce around between a low and a high price (called a "range bound" stock), and then they buy when it nears the low and sell when it nears the high. They may also sell short when the stock reaches the high point, trying to profit as the stock falls to the low and then close out the short position.
Spread tradingThis high-speed technique tries to profit on temporary changes in sentiment, exploiting the difference in the bid-ask price for a stock (also called a spread). For example, if a buyer’s bid price drops suddenly, the day trader might step in to buy and then try to quickly re-sell at the stock’s ask price or higher, earning a small “spread” on the transaction.
FadingThis sees a trader short-selling a stock that has gone up too quickly when buying interest starts to wane. The trader might close the short position when the stock falls or when buying interest picks up.
Momentum, or trend followingThis strategy tries to ride the wave of a stock that’s moving (either up or down), perhaps to due to an earnings report or some other news. Traders will buy a rising stock, or “fade” a falling one, anticipating that the momentum will continue.

Why day traders so rarely succeed

Day trading is so difficult for a variety of reasons, but they boil down to two major categories.

First, 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.

Second, retail investors are 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.

The safest way to approach day trading

If you’re dead set on day trading, open a practice account and give it a go first before committing any real money. Many brokerage accounts offer practice modes, in which you can make hypothetical trades and observe the results. Above all, be honest about how you would trade in real life, since you want an accurate gauge of performance.

If you try this and still feel ready to try the real thing, see the best platforms for day trading.

If the practice exercise turns you off of day trading, 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.

Here are steps to further advance your investing expertise:

James F. Royal, Ph.D., is a staff writer at NerdWallet, a personal finance website. Email: jroyal@nerdwallet.com. Twitter: @JimRoyalPhD.