Day trading is the act of buying and selling the same security over the course of a single trading day. For example, let’s say you purchase three shares of Apple stock when the market opens and sell them that same afternoon. That’s a day trade.
Day trades can be executed in any market but occur most often in the stock and forex markets. Day traders typically aim to end the day with no open positions, which means they don’t hold securities overnight.
Day traders apply a significantly different approach to trading than buy-and-hold investors. Unlike passive strategies that seek long-term stability when selecting securities, day traders apply an active trading strategy that capitalizes on market volatility. Day traders use short-term market fluctuations and high leverage to their advantage, pouncing on small price movements to turn a profit.
To make money on such small price movements, day traders must be willing to invest sizable sums. That, or trade options contracts, as the costs are often lower — though risks remain high. The more you invest, the more you have to gain — and more you stand to lose.
Day trading is a high-risk, high-reward investment strategy. The best way to lower your risk is to familiarize yourself with common day trading pitfalls.
Time commitment. Day trading requires a hefty investment of time — time that might have been better spent elsewhere should your strategy fall through.
Fast-paced. Day trading is exciting: Each day you could see any number of securities shift in and out of your portfolio for immediate gains or losses.
There are a few ways you can reduce risk while day trading.
Outside these practices, day traders can also reduce risk by using the 1% rule — a twist on the popular core and explore strategy.
Christopher Liew, Chartered Financial Analyst (CFA), tells Finder: “Day traders can employ a common risk-management strategy called the 1% rule wherein traders don’t invest beyond 1% of their entire trading account in a single trade to manage possible losses.”
The 1% rule isn’t unlike the core and explore strategy — a strategy that allocates a majority of portfolio funds to low-cost diversified funds and leaves the rest for high-risk trades like growth stocks or day trades. Core and explore might reserve 10% for riskier trades instead of 1% — but your number depends on the amount of risk you can afford to take.
Michael Shea, certified financial planner (CFP) and IRS enrolled agent, offers a similar approach: “If you want to day trade, set aside an amount of money you’re 100% okay with losing. Make sure your retirement portfolio and savings are taken care of first, and if you have money left over to gamble on day trading, then have at it.”
There are several short-term strategies you can explore. Here are a few examples.
Trend trading: This involves studying the past price movements of stocks within a specific time frame, usually several months. From this evidence, trend traders make predictions about the direction stock prices will make in the future. They aim to buy stocks early during an upward trend and sell when they believe they will reach their peak based on the available evidence.
Swing trading: This strategy entails holding onto a stock for a period of between a few days to a few weeks. Swing traders use different analytical methods and tools to predict the highs and lows of a stock’s price movements and then sell on the upside if those predictions materialize.
News-based trading: This strategy relies on — you guessed it – news. News events can have a powerful impact on affected industries and sectors. News-based trading aims to wield the volatility triggered by news events to the trader’s advantage.
To execute these strategies, you’ll need a brokerage account.
Interactive Brokers offers an impressive range of tools and low fees for active or professional investors.
| Available asset types | Stocks, Bonds, Options, Mutual funds, ETFs, Cryptocurrency, Futures, Forex, Treasury Bills |
|---|---|
| Stock trade fee | $0 |
| Option trade fee | $0 + $0.65/contract |
| Annual fee | 0% |
The pattern day trading rule applies to day traders that execute at least four day trades within five business days. The rule was established by the Financial Industry Regulatory Authority (FINRA), is governed by the US Securities and Exchange Commission (SEC) and applies to all US brokerages. Pattern day trading isn’t illegal — but the pattern day trading rule limits who can execute day trades and when.
Your broker may deem you a pattern day trader if your day trading activity accounts for more than 6% of your total trading activity in five days. At this point, you’re required to bring your account balance above $25,000 to continue trading.
If you’ve been marked as a pattern day trader and fail to maintain a minimum account balance of $25,000, you won’t be able to day trade.
If you’d like to day trade and don’t have the means to bring your account balance above $25,000, there are a few loopholes:
Some brokers will let you day trade in a cash account — but only using settled funds. Cash accounts must use settled funds to cover trades to avoid freeriding, which is the act of buying and selling securities from a cash account without having the capital to cover the trade. Stock and ETF transactions take three days to settle, while mutual funds and options settle in one day.
Freeriding is illegal and prohibited by the SEC. Traders who engage in freeriding will have their accounts suspended for 90 days. The freeriding rule makes it very difficult to day trade using a cash account.
Margin trading is trading with borrowed money. When you trade on margin, you borrow funds from your broker to execute a trade. You’ll be asked to pay back what you owe with interest and your account serves as collateral for the loan.
So long as the trade moves in your favor, trading on margin can be a lucrative practice: You increase your buying power by borrowing funds, execute a profitable trade, pay back what you owe and pocket the profit.
The problem with margin trading is that the potential to compound the results of a trade swings both ways: you may increase your profit — but you may also multiply your losses. Stop-loss orders may help cushion the impact, but margin trading remains an inherently risky strategy best reserved for those with extensive trading experience.
The right broker can make or break your day trading experience. Here’s what to look for in a broker:
Sophisticated analytical software can help inform day trading decisions and may include any of the following:
Most beginner to intermediate traders don’t require these tools to execute trades, so don’t be surprised if you find platforms like Robinhood and Public lacking. That said, platforms that cater to advanced traders, like Interactive Brokers and TD Ameritrade, may be better equipped.
Day trading is ill-suited to beginners. If you’re new to investing, you may be better off with a more beginner-friendly investing strategy.
This strategy involves purchasing stocks and — you guessed it — holding them. Sometimes for years. Buy-and-hold investors aim to weather market volatility by holding onto their stocks regardless of how the market moves.
The rationale behind this long-term strategy is that even if the market faces a downturn, it will eventually recover. For buy-and-hold investors, long-term gains are more appealing than trying to take advantage of small fluctuations in the market.
You could invest in index funds that track the S&P 500 and other indices. These funds aim to reflect the return of their respective indices rather than take the inherently riskier approach of beating the market.
In fact, the average annualized total return of the S&P 500 index over the past 90 years is 9.8%. The S&P 500 index is composed of the biggest companies in America by market capitalization and is often seen as a reliable indicator of the overall market’s shape.
A robo-advisor is a digital investment service designed to pick and manage your investments for you. It’s a practical service for those new to investing, as you don’t need to actively monitor your portfolio: The robo-advisor does it all for you.
Many robo-advisors recommend diversified portfolios based on your unique investment goals. Once you fund your account, it selects your investments and automatically rebalances your portfolio if anything strays too far from your goals.
Day trading isn’t for everyone. It’s potentially profitable, but even with a solid strategy, a reliable broker and the right tech, the risk of losing money is high. Day traders must be prepared to lose capital, especially when trading on a margin.
The right broker can play a pivotal role in your success as an investor. Explore your platform options among multiple providers to find the best account for your needs.
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