Stock markets rang in the new year on a high note in 2019 and kept the party going, until they started stumbling in May. Long-term traders are worried the 10-year bull run in stocks is over. Day traders are giddy with the prospect of more volatility ahead…
Day traders love price volatility. During the downturn, the passive investor will look to buy cheap value stocks in anticipation of their price appreciating over time. The active day trader will buy long and sell short on significant price movements many times in a day.
What is Day Trading?
Day trading involves buying and selling the same security within the same day with a view to making a quick profit from changes in the price. These intraday traders make money by skimming small profits on high trading volumes. They magnify these profits by borrowing on margin.
- A trader buys 10 CFDs on Apple stock in the morning expecting a positive quarterly earnings announcement in the afternoon, and then places an order to sell the stock when the price rises $5. The Apple stock price is $175 (x 10 shares = $1,750], but the trader is only required to pay a 25 percent margin rate (or $43.75 x 10 shares = $437.50). When Apple announces record-blowing iPhone sales, the stock rises to $180 and the limit order is executed for a profit of $50.
- A speculator shorts an e-mini Euro Futures contract when the short-term moving average crosses below the long-term moving average, with a 2 pip stop-loss. The margin rate is 25 percent of the $1,100 contract. Selling volume spikes and one minute later the trade executes when the price falls 2 pips.
- Algorithmic traders execute in fractions of a second. They develop programs to identify discrepancies in prices across thousands of securities. These clever bots buy and sell securities in milliseconds.
Why Day Trade?
The day trader is an investor with a higher appetite for risk, but even this risk taker should never risk money they cannot afford to lose. Keep in mind that over the long term passive investors outperform active investors. Even if you are a pro at timing the market, high trading fees will reduce your returns.
- Small investment gains on high volume trading
- Increased borrowing power with margin borrowing
- High risk of loss of capital
- High price volatility
- High active trading costs
- Disadvantaged against high speed trading systems
How Much can I Make Day Trading?
Many factors affect how much money you can make as a day trader. The amount of leverage you use is a key parameter. On a forex trade, a retail trader can use 1:30 leverage whereas a professional trader can use 1:100, or much higher, leverage.
Prudent traders use the 1 percent risk rule: Never trade more than 1 percent of the value of your portfolio on one trade. On a $1,000 with 3:1 leverage, you will have $3,000 in buying power. If you want to trade Apple stock at $175\share and your portfolio value is $100,000, applying the 1 percent rule, you have $1,000 to trade. So you can buy 5.7 shares. Your stop loss will determine your potential loss (let’s set it at $170) and your limit your potential gain (let’s set it at $180). Your highest potential gain is ($5 x 5.7 shares) x 3 times leverage, or $85.50, which is also your highest potential loss.
Day Trading Buying Power and Account Minimums
Before you start day trading, ensure you are familiar with the following margin rules and account limits.
Day Trading – Day trading involves completing a round trip trade on the same day. If a trader buys a security and then sells it on the same day, it is considered a day trade. Conversely, if a trader sells short a security and buys it on the same day, it is considered a day trade.
Margin Trading – Most day traders borrow money from brokers to trade. Trading on margin involves using the money and securities in a broker account as collateral for the loan. How much the trader can borrow to trade is based on his risk profile and the value of the investment account (cash + securities). The ratio of the amount in the account to the amount borrowed is called leverage.
Pattern Trading – In the US markets, day traders are considered pattern traders if they borrow on margin, trade the same security four or more times within five business days, and day trading is six percent of the trade activity for that period. Once a day trader is considered a pattern trader, they are required to maintain a minimum balance of $25,000 to day trade. This balance may be a combination of cash and securities. The pattern day trading rule does not apply to futures trading, making futures a popular day trading instrument.
Margin Call – If the value of the investment account falls below the maintenance margin, the trader will have several days to restore the account maintenance balance through cash and/or securities.
Leverage – Leverage is the buying power gained through margin lending expressed as a ratio of the amount in the account to the amount borrowed. If you have the $25,000 pattern trading minimum in your account and are allowed 4:1 leverage, you can borrow up to $100,000 to trade.
How to Start Day Trading for Beginners
Popular Day Trading Strategies
Popular trading strategies have a large influence on price movement. When traders trade the same pattern, they contribute to the sustaining of the pattern. The price intelligence in the simple candlestick provides key price movement indications for many traders.
If this were all there was to trading, we would all be rich. Many others factors can influence price, including economic news, corporate earnings reports, and political events. The largest trades that have the most influence on price are often hidden on dark pools, which allow large traders to trade without exposing their price or volume levels. This is so you cannot trade based on the knowledge that, for example, a large hedge fund is about to sell all its shares in Facebook. If this information were to be made public, all traders would rush to sell their Facebook stock before the inevitable price decline.
Trend Trading – The trend is your friend, if you can follow it. In an uptrend, trend traders draw diagonal lines upwards that trace higher highs and higher lows. In a downtrend, the descending lines follow lower lows and lower highs. Trading volume is a good indicator of whether or not the trend will continue.
Breakouts – The break out trader uses historical pricing data to forecast future price movements. Price resistance levels are established after the price has reached the same high multiple times (often 3x). Support levels form where the price hits the same lows. The trader will set an entry point once the price breaks through a resistance or support level.
Momentum – The momentum behind a price movement can be an indicator of how much strength is behind a price trend. If trading volume is strong, the trend is more likely to be sustained while weak trading volume could signal a price reversal.
Pivot Points – These popular price trend indicators take a trading session’s highs, lows and close to predict the price trend in the next trading period. The trading period can be on the order of minutes or months.
Scalping – Scalpers make money by taking small profits across many trades. They exit as soon as a trade starts losing money rather than wait around hoping the price will reverse. The small gains can add up to a large profit.
Retracement – Prices seldom take off on an upward trajectory without retracing their movements down. Retracers try to predict which retracement signals a large price reversal. They increase their profit potential by buying in the retracement before prices reverse. Fibonacci ratios are popular retracement levels (23.6%, 38.2%, 61.8%).
No strategy is consistently reliable but they can provide an indication of when a price trend is going to continue or reverse. Most day traders combine more than one trading strategy and indicator.
In the US, day traders are considered pattern traders – traders who buy and sell the same securities four days within a five-day period. Pattern traders are required to maintain a minimum investment account balance of $25,000. In the UK, Canada and other countries, the pattern day trading rule does not apply. Each broker will have different account limits.
Many factors affect how much money you can make as a day trader. The amount of leverage you use is a key parameter. On a forex trade, a retail trader can use 1:30 leverage whereas a professional trader can use 1:100, or much higher, leverage. Prudent traders use the 1 percent risk rule: Never trade more than 1 percent of the value of your portfolio on one trade. On a $1,000 with 3:1 leverage, you will have $3,000 in buying power. If you want to trade Apple stock at $175\share and your portfolio value is $100,000, applying the 1 percent rule, you have $1,000 to trade. So you can buy 5.7 shares. Your stop loss will determine your potential loss (let’s set it at $170) and your limit your potential gain (let’s set it at $180). Your highest potential gain is ($5 x 5.7 shares) x 3 times leverage, or $85.50, which is also your highest potential loss.
Most day traders use margin. The biggest mistake traders make is using the full margin allotment they are allowed. A beginner day trader should use a small fraction of the margin consistent with the trader’s risk profile.
Stop orders are a popular way of limiting downside risk while trading. The two most popular are:
Stop-loss order – Stops our the trade when the price reaches the determined amount.
Trailing stop – Follows the price within a range (e.g. 10 pips). The trade is executed when the stock price passes through the target price.
Because binary options have a high risk of loss, they are banned in many countries. In Europe, professional traders may trade them but they are off limits to retail traders. Anyone anywhere in the world can download a binary options broker app and start trading. If the broker goes out of business, your losses will not be covered by investment account insurance. Also be aware that many binary option dealers have been shut down owing to fraudulent activities.
According to the regulator FINRA, once an account is identified as engaging in pattern trader, they are typically required to maintain a $25,000 deposit.
Day traders can trade up to four times their account balance, but the amount could vary by broker. If you receive a margin call, your buying power will be reduced to two times the account balance. If you do not meet the margin call within five days, your buying power will be restricted and you will have to trade on a cash only basis.