A day trader is a type of trader who executes a relatively large volume of short and long trades to capitalize on intraday market price action. The goal is to profit from very short-term price movements. Day traders can also use leverage to amplify returns, which can also amplify losses.
While many strategies are employed by day traders, the price action sought after is a result of temporary supply and demand inefficiencies caused due to purchases and sales of the asset. Typically positions are held from periods of milliseconds to hours and are generally closed out before the end of the day so that no risk is held after hours or overnight.
Basics of a Day Trader
There is no special qualification required to become a day trader. Instead, day traders are classified based on the frequency of their trading. The Financial Industry Regulatory Authority (FINRA) and U.S. Securities and Exchange Commission classify day traders based on whether they trade four or more times during a five-day span, provided the number of days trades is more than 6% of the customer’s total trading activity during that period or the brokerage/investment firm where they have opened an account considers them a day trader.
A day trader often closes all trades before the end of the trading day, so as not to hold open positions overnight. A day trader’s effectiveness may be limited by the bid-ask spread, trading commissions, as well as expenses for real-time news feeds and analytics software. Successful day trading requires extensive knowledge and experience. Day traders employ a variety of methods to make trading decisions. Some traders employ computer trading models that use technical analysis to calculate favorable probabilities, while some trade on their instinct.
A day trader is primarily concerned with the price action characteristics of a stock. This is unlike investors, who use fundamental data to analyze the long-term growth potential of a company to decide whether to buy, sell or hold its stock.
Price volatility and average day range are critical to a day trader. A security must have sufficient price movement for a day trader to achieve a profit. Volume and liquidity are also crucial because entering and exiting trades quickly are vital to capturing small profits per trade. Securities with a small daily range or light daily volume would not be of interest to a day trader.
Pattern Day Trader Designation
A pattern day trader (PDT) is a regulatory designation for those traders or investors that execute four or more day trades over the span of five business days using a margin account.
The number of days trades must constitute more than 6% of the margin account’s total trade activity during that five-day window. If this occurs, the trader’s account will be flagged as a PDT by their broker. The PDT designation places certain restrictions on further trading; this designation is put in place to discourage investors from trading excessively.
Day Trader Techniques
Day traders are attuned to events that cause short-term market moves. Trading the news is a popular technique. Scheduled announcements such as economic statistics, corporate earnings, or interest rates are subject to market expectations and market psychology. Markets react when those expectations are not met or are exceeded, usually with sudden, significant moves, which can benefit day traders.
Another trading method is known as fading the gap at the open. When the opening price shows a gap from the previous day’s close, taking a position in the opposite direction of the gap is known as fading the gap. For days when there is no news or there are no gaps, early in the morning, day traders will take a view of the general direction of the market.
If they expect the market to move up, they would buy securities that exhibit strength when their prices dip. If the market is trending down, they would short securities that exhibit weakness when their prices bounce.
Most independent day traders have short days, working two to five hours per day. Often they will practice making simulated trades for several months before beginning to make live trades. They track their successes and failures versus the market, aiming to learn by experience.
Day Trader Strategies
Day traders use several intraday strategies. These may include:
- Scalping: this strategy attempts to make numerous small profits on small price changes throughout the day, and may also include identifying short-lived arbitrage opportunities.
- Range trading: this strategy primarily uses support and resistance levels to determine buy and sell decisions. This trading style may also go by the name swing trading if positions are held for weeks rather than hours or days.
- News-based trading: this strategy typically seizes trading opportunities from the heightened volatility around news events and headlines.
- High-frequency trading (HFT): these strategies use sophisticated algorithms to exploit small or short-term market inefficiencies up to several thousand times in a single day.
Advantages and Disadvantages of Day Trading
The most significant benefit of day trading is that positions are not affected by the possibility of negative overnight news that has the potential to impact the price of securities materially. Such news includes vital economic and earnings reports, as well as broker upgrades and downgrades that occur either before the market opens or after the market closes.
Trading on an intraday basis offers several other key advantages. One advantage is the ability to use tight stop-loss orders—the act of raising a stop price to minimize losses from a long position. Another includes the increased access to margin—and hence, greater leverage. Day trading also provides traders with more learning opportunities.
However, with every silver lining, there are also storm clouds. While day trading can be highly profitable, it still comes with plenty of risks.
Disadvantages of day trading include insufficient time for a position to see increases in profit, in some cases any profit at all, and increased commission costs due to trading more frequently, which eats away at the profit margins a trader can expect. Day traders that engage in short selling or use margin to leverage long positions can see losses amplify quickly, leading to margin calls.
- Positions are usually closed at the end of each day and are so unaffected by risk from overnight news or off-hours broker moves.
- Tight stop-loss orders can protect positions from extreme movements.
- Regular traders have access to increased leverage and lower commissions.
- Numerous trades increase the hands-on learning experience.
- Frequent trades do mean multiple commission costs.
- Some assets are off-limits, like mutual funds.
- There may not be sufficient time for a position to realize a profit before it has to be closed out.
- Losses can mount quickly, especially if the margin is used to finance purchases. Margin calls are a real risk.