Day trading involves buying and selling financial instruments within a single trading day. Day traders will normally close out their positions at the end of each day, starting afresh at the start of the next day. Here’s a guide to how it works.
If you’re new to trading you’re likely to start coming across a number of terms that attempt to describe trading personalities and techniques. Terms like swing traders, momentum traders, trend traders and day traders. In each case, the object is the same: to make money by profiting from moves in asset prices. The difference between them is the technique employed to try and make that money and the trading time-frame.
Day trading is not for the part timer. It takes time, focus, dedication and a specific mindset. It’s the polar opposite of investing, where you seek to benefit from price movements over many years. Day trading involves taking fast decisions, and you make money by executing a large number of trades for a relatively small profit each time.
The term ‘day trader’ is often associated with markets that have fixed closes, such as the equity market, although in reality a day trader could trade any asset. In the equity market, the trader will exit all positions before the market closes to avoid what is known as ‘gapping risk.’ This is where an individual stock price could open significantly higher or lower (a gap) than the previous day’s close as fresh overnight news and influences are priced into the stock.
You can be a day trader and still trade markets that are open for 24 hours (or almost 24 hours), such as forex markets and futures markets for instance for crude oil and indices including the S&P 500. Day traders will generally trade a specific period in the session, and most seem to gravitate to the late European/early US day, when there’s traditionally greater liquidity and volatility in the markets.
Day trading and risk management
Take a look at the world’s most famous and successful traders and they all have one thing in common: they develop a trading strategy that they have confidence in. They have the control and discipline to provide them with either a statistical edge or a positive expectancy that they will be the one taking capital from the market. They will manage their trading accounts as though they were running a business and will recognise that they are managers of risk. They will protect the capital in their account above all else. Just as with any types of trading, risk management tools such as stops and limits are an essential part of the trading tool box.
Day traders have to think very differently from investors. Buying low and selling high might not always be in their best interests. There are a large number of strategies that day traders can employ, including mean reversion strategies, following money flows and trading trends. They could also look at swing trading or scalping.
What’s in a trading strategy?
Trend trading: trend traders try to make money by studying the direction of asset prices and buying or selling depending on which direction the trend is taking. If the trend is upwards and prices are making a succession of higher highs, then traders take a long position by buying. If the trend is downwards and prices are making a succession of lower lows then traders take a short position by selling.
Swing trading: swing traders look to take advantage of price movements within a bigger trend. Prices never go in one direction in a trend and swing traders look to make money from the up and down movements that occur in a shorter time frame.
Scalping: this strategy involves taking profits on small price changes, and is focused on achieving a high win rate. The theory is you can just as easily build a big trading account by taking smaller profits time and time again as you can by doing fewer trades and letting profits run. Scalping requires a very strict exit strategy as losses can very quickly counteract the profits.
Mean reversion: This strategy is based on the theory that prices, and indeed other measures of value like price-to-earnings ratios, always eventually move back towards the historical mean. The strategy looks for assets that are priced furthest away from their historical means and looks to take advantage.
Money flows: This strategy uses the money flow indicator which signals whether an asset might be oversold or overbought. It uses volume and price rather than the price alone. A reading of 80 or higher indicates overbought conditions and is a signal for the trader to sell, and a reading of 20 or below indicates oversold conditions and is a signal to sell.
Run your profits and cut your losses
You’ll often hear it said that a successful trader cuts losing trades quickly but allows profitable trades to run, and that’s as important in day trading as in any other strategy. By doing this, a trader could have fewer winning trades than losing trades and still grow the capital in the trading account. A trader doesn’t always need to be right, but needs to quickly acknowledge when they’re wrong and take action so that they’re making more money on winning trades than they’re losing on the ones that go wrong.
There is always conjecture on whether a trader should target a high win/loss ratio or look more closely at the risk-to-reward ratio. Successful day traders will often have low win rates, even below 40%, but will look to target a risk-to-reward ratio of at least 1:2 (meaning the trader expects to double the money that he or she is willing to risk in making that trade). That is a consideration for the individual, but one thing is true: there is nothing wrong with making a mistake and taking a small loss, but staying wrong and realising a big loss is the best way to end a journey as a short-term trader.
By Chris Weston – Sep 14, 2017
Originally published by IG Markets