Day trading is the practice of buying and selling a financial asset within a single trading day. It’s a practice that is commonly used in foreign exchange and stock markets. To be successful in day trading, investors require high levels of financial leverage to maximise the profit they can earn from small movements in high liquidity stocks or currencies.
Having robust short-term strategies are crucial to successful day trading, as is discipline in sticking with your plan. Knowledge and experience in the marketplace is also important, as not having a good understanding of market fundamentals increases the risk of losses.
How day trading works
Market volatility is key to day trading, these types of investors rely on stock or market fluctuations in order to earn their profits. They seek out stocks that have a share price that bounces around a lot throughout the day. Changes in share price can be caused by good or bad news events, earnings reports or just general market sentiment.
Day traders also look for high liquidity stocks that allow them to move in and out of a position with little effect on the stock’s price. There are two ways day traders can make a profit, they may buy a stock if its price is increasing in order to make a profit or they may short sell it if the price is declining so they can profit from the stock’s fall.
Day trading is time consuming, as traders may buy and sell the same stock many times in a single day and they may change strategies.
Types of day trading
Day traders generally seek an edge over the rest of the market. They use their understanding of the market and analytic skills to identify opportunities that could be lucrative. Many day traders will choose a single type of trade, but some will take different types and choose the one that suits the state of the market, these include:
- Trend trades: trades in the trending direction of the current price movement. For example, buying if the price is increasing.
- Counter-trend trades: trading against the trending direction of the current price movement. For example, selling if the price is increasing.
- Ranging trades: trades that move in range between two prices. This is used when the market is moving sideways.
Seasoned day traders will also use a variety of intraday strategies including:
- Scalping: attempting to make a number of small profits on small price changes throughout the day.
- Range trading: using support and resistance levels to determine buy and sell decisions.
- News-based trading: capitalizing on trading opportunities from heightened volatility around news events.
- High-frequency trading: This strategy uses complicated algorithms to exploit small or short-term market inefficiencies.
Day traders that do it to make a living typically work for a large institution. This type of day trader has a competitive advantage as they have access to a direct line, a trading desk and large amounts of capital and leverage. In some cases they will also have access to expensive analytical software to help them identify opportunities and lower their exposure to risk.
Day traders who do it for a hobby are generally single investors who are using their own finances. Few of them have access to a trading desk, but may have strong relationships with a brokerage. The limited resources available to them can mean that their investments are riskier.
Advantages of day trading
Some of the advantages of day trading include:
Avoids overnight risk
As day traders buy and sell stocks within a single day they mitigate the overnight risk. Overnight risks occur while the market is closed and when traders are sleeping. Unexpected dramatic shifts can occur overnight due to economic, political or military news not only in your country but around the world.
Day trading can be profitable
Day trading if done successfully can lead to good profits quickly. Given the large capital fund many day traders have access to means that their profits can be huge in a very short period of time compared to long-term investing.
There’s no overthinking
When day trading you have to make a decision in a split second, the markets will not wait for you. The fast-paced nature of the investment practice means that overthinking is eliminated, purely because there isn’t time.
Disadvantages of day trading
As with all types of investing there are some disadvantages of day trading, including:
Can be high risk
Relying on market volatility to make profits can be a risky strategy, especially for less experienced day traders who are not seasoned at reading the markets and identifying trends. Given the short trading period, the margin for error in day trading is tiny and one small mistake could cost day traders dearly.
Day trading is expensive
Day trading not only requires a large amount of capital to begin with, but can also be subject to costly commissions and transaction fees. These costs can eat into any profits you make, so day traders need to make sure that their profits are high enough to cover the costs and still be beneficial. Profits from day trading are also subject to short-term capital gains tax, which is the same rate as income tax.
High levels of pressure and stress
Riding the highs and lows of day trading can be incredibly stressful, for this reason many traders only practice day trading for a relatively short period of time.