Day trading

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Chart of the NASDAQ-100 between 1994 and 2004, including the dot-com bubble NASDAQ IXIC - dot-com bubble small.png
Chart of the NASDAQ-100 between 1994 and 2004, including the dot-com bubble

Day trading is a form of speculation in securities in which a trader buys and sells a financial instrument within the same trading day, so that all positions are closed before the market closes for the trading day to avoid unmanageable risks and negative price gaps between one day's close and the next day's price at the open. Traders who trade in this capacity are generally classified as speculators. Day trading contrasts with the long-term trades underlying buy-and-hold and value investing strategies. [1] [2] Day trading may require fast trade execution, sometimes as fast as milli-seconds in scalping, therefore direct-access day trading software is often needed. [3]

Contents

Day trading is a strategy of buying and selling securities within the same trading day. According to FINRA, a "day trade" involves the purchase and sale (or sale and purchase) of the same security on the same day in a margin account, covering a range of securities including options. An individual is considered a "pattern day trader" if they execute four or more day trades within five business days, given these trades make up over six percent of their total trades in the margin account during that period. [4] Pattern day traders must adhere to specific margin requirements, notably maintaining a minimum equity of $25,000 in their trading account before engaging in day trading activities. [5]

Day traders generally use leverage such as margin loans. In the United States, Regulation T permits an initial maximum leverage of 2:1, but many brokers will permit 4:1 intraday leverage as long as the leverage is reduced to 2:1 or less by the end of the trading day. In other countries margin rates of 30:1 or higher are available. In the United States, based on rules by the Financial Industry Regulatory Authority, people who make more than 3 day trades per 5-trading-day period are termed pattern day traders and are required to maintain $25,000 in equity in their accounts. [6] However, a day trader with the legal minimum of $25,000 in their account can buy $100,000 (4× leverage) worth of stock during the day, as long as half of those positions are exited before the market close. Because of the high risk of margin use, and of other day trading practices, a day trader will often have to exit a losing position very quickly, in order to prevent a greater, unacceptable loss, or even a disastrous loss, much larger than their original investment, or even larger than their account value. [7] Since margin interest is typically only charged on overnight balances, the trader may pay no interest fees for the margin loan, though still running the risk of margin calls. Margin interest rates are usually based on the broker's call rate.

Some of the more commonly day-traded financial instruments are stocks, options, currency (including cryptocurrency), contracts for difference, and futures contracts such as stock market index futures, interest rate futures, currency futures and commodity futures. Some day traders use an intra-day technique known as scalping that has the trader holding a position briefly, for a few minutes to only seconds.

Day trading was once an activity that was exclusive to financial firms and professional speculators. Many day traders are bank or investment firm employees working as specialists in equity investment and investment management. Day trading gained popularity after the deregulation of commissions in the United States in 1975, the advent of electronic trading platforms in the 1990s, and with the stock price volatility during the dot-com bubble. [8] Recent 2020 pandemic lockdowns and following market volatility has caused a significant number of retail traders to enter the market. [9]

Day traders may be professionals that work for large financial institutions, are trained by other professionals or mentors, do not use their own capital, or receive a base salary of approximately $50,000 to $70,000 as well as the possibility for bonuses of 10%–30% of the profits realized. [10] Individuals can day trade with as little as $100, [11] or even less, with fractional shares.

History

GME Short Squeeze weekly chart in 2021 where price squeezed over %1,000 in 2021 providing numerous day trading opportunities. GME.jpg
GME Short Squeeze weekly chart in 2021 where price squeezed over %1,000 in 2021 providing numerous day trading opportunities.

Before 1975, stockbrokerage commissions in the United States were fixed at 1% of the amount of the trade, i.e. to purchase $10,000 worth of stock cost the buyer $100 in commissions and same 1% to sell and traders had to make over 2% to cover their costs, which was not likely in a single trading day.

In 1975, the U.S. Securities and Exchange Commission (SEC) prohibited fixed commission rates, and commission rates dropped significantly.

Financial settlement periods used to be much longer. Before the early 1990s at the London Stock Exchange, for example, stock could be paid for up to 10 working days after it was bought, allowing traders to buy (or sell) shares at the beginning of a settlement period only to sell (or buy) them before the end of the period hoping for a rise in price. This activity was identical to modern day trading, but for the longer duration of the settlement period. But today, to reduce market risk, the settlement period is typically T+2 (two working days) and brokers usually require that funds be posted in advance of any trade. Reducing the settlement period reduces the likelihood of default, but was impossible before the advent of electronic ownership transfer.

Electronic communication networks

Electronic communication networks (ECNs), large proprietary computer networks on which brokers can list a certain amount of securities to sell at a certain price (the asking price or "ask") or offer to buy a certain amount of securities at a certain price (the "bid"), first became a factor with the launch of Instinet in 1969. However, at first, they generally offered better pricing to large traders. [12]

The next important step in facilitating day trading was the founding in 1971 of NASDAQ - a virtual stock exchange on which orders were transmitted electronically. Moving from paper share certificates and written share registers to "dematerialized" shares, traders used computerized trading and registration that required not only extensive changes to legislation but also the development of the necessary technology: online and real time systems rather than batch; electronic communications rather than the postal service, telex or the physical shipment of computer tapes, and the development of secure cryptographic algorithms.

These developments heralded the appearance of "market makers": the NASDAQ equivalent of a NYSE specialist. A market maker has an inventory of stocks to buy and sell, and simultaneously offers to buy and sell the same stock. Obviously, it will offer to sell stock at a higher price than the price at which it offers to buy. This difference is known as the "spread". The market maker is indifferent as to whether the stock goes up or down, it simply tries to constantly buy for less than it sells. A persistent trend in one direction will result in a loss for the market maker, but the strategy is overall positive (otherwise they would exit the business). Today there are about 500 firms who participate as market makers on ECNs, each generally making a market in four to forty different stocks. Without any legal obligations, market makers were free to offer smaller spreads on electronic communication networks than on the NASDAQ.

After Black Monday (1987), the SEC adopted "Order Handling Rules" which required market makers to publish their best bid and ask on the NASDAQ. [13]

Another reform made was the "Small-order execution system", or "SOES", which required market makers to buy or sell, immediately, small orders (up to 1,000 shares) at the market maker's listed bid or ask. The design of the system gave rise to arbitrage by a small group of traders known as the "SOES bandits", who made sizable profits buying and selling small orders to market makers by anticipating price moves before they were reflected in the published inside bid/ask prices. The SOES system ultimately led to trading facilitated by software instead of market makers via ECNs. [14]

In the late 1990s, existing ECNs began to offer their services to small investors. New ECNs arose, most importantly Archipelago (NYSE Arca) Instinet, SuperDot, and Island ECN. Archipelago eventually became a stock exchange and in 2005 was purchased by the NYSE.

The ability for individuals to day trade via electronic trading platforms coincided with the extreme bull market in technological issues from 1997 to early 2000, known as the dot-com bubble. From 1997 to 2000, the NASDAQ rose from 1,200 to 5,000. Many naive investors with little market experience made huge profits buying these stocks in the morning and selling them in the afternoon, at 400% margin rates. An unprecedented amount of personal investing occurred during the boom and stories of people quitting their jobs to day trade were common. [15]

In March 2000, this bubble burst, and many less-experienced day traders began to lose money as fast, or faster, than they had made during the buying frenzy. The NASDAQ crashed from 5000 back to 1200; many of the less-experienced traders went broke, although obviously it was possible to have made a fortune during that time by short selling or playing on volatility. [16] [17]

In parallel to stock trading, starting at the end of the 1990s, several new market maker firms provided foreign exchange and derivative day trading through electronic trading platforms. These allowed day traders to have instant access to decentralised markets such as forex and global markets through derivatives such as contracts for difference. Most of these firms were based in the UK and later in less restrictive jurisdictions, this was in part due to the regulations in the US prohibiting this type of over-the-counter trading. These firms typically provide trading on margin allowing day traders to take large position with relatively small capital, but with the associated increase in risk. The retail foreign exchange trading became popular to day trade due to its liquidity and the 24-hour nature of the market.

Profitability and risks

Because of the nature of financial leverage and the rapid returns that are possible, day trading results can range from extremely profitable to extremely unprofitable; high-risk profile traders can generate either huge percentage returns or huge percentage losses. [18]

Day trading is risky, and the U.S. Securities and Exchange Commission has made the following warnings to day traders: [19]

Most day traders lose money. [20] [21] [22]

A 2019 research paper analyzed the performance of individual day traders in the Brazilian equity futures market. Based on trading records from 2012 to 2017, it was concluded that day trading is almost uniformly unprofitable:

We show that it is virtually impossible for individuals to compete with HFTs and day trade for a living, contrary to what course providers claim. We observe all individuals who began to day trade between 2013 and 2015 in the Brazilian equity futures market, the third in terms of volume in the world, and who persisted for at least 300 days: 97% of them lost money, only 0.4% earned more than a bank teller (US$54 per day), and the top individual earned only US$310 per day with great risk (a standard deviation of US$2,560). We find no evidence of learning by day trading. [23]

An article in Forbes quoting someone from an educational trading website stated that "the success rate for day traders is estimated to be around only 10%, so ... 90% are losing money," adding "only 1% of [day] traders really make money." [24]

Techniques

Day trading requires a sound and rehearsed method to provide a statistical edge on each trade and should not be engaged on a whim. [25]

The following are several basic trading strategies by which day traders attempt to make profits. In addition, some day traders also use contrarian investing strategies (more commonly seen in algorithmic trading) to trade specifically against irrational behavior from day traders using the approaches below. It is important for a trader to remain flexible and adjust techniques to match changing market conditions. [26]

Some of these approaches require short selling stocks; the trader borrows stock from their broker and sells the borrowed stock, hoping that the price will fall and they will be able to purchase the shares at a lower price, thus keeping the difference as their profit. There are several technical problems with short sales: the broker may not have shares to lend in a specific issue, the broker can call for the return of its shares at any time, and some restrictions are imposed in America by the U.S. Securities and Exchange Commission on short-selling (see uptick rule for details). Some of these restrictions (in particular the uptick rule) don't apply to trades of stocks that are actually shares of an exchange-traded fund (ETF).

Swing Trading

Swing trading is a strategy aimed at gaining profit from stock price fluctuations over a period of several days to weeks. This method contrasts with day trading, where positions are closed within the same day. Swing traders utilize technical analysis to identify potential price movements and determine optimal trading moments.

Trend following

Trend following, or momentum trading, is a strategy used in all trading time-frames, assumes that financial instruments which have been rising steadily will continue to rise, and vice versa with falling. Traders can profit by buying an instrument which has been rising, or short selling a falling one, in the expectation that the trend will continue. These traders use technical analysis to identify trends. [27]

As a Strategy for Day Trading, a robust trading strategy traditionally used for long-term investments in various asset classes, can also be adapted for day trading. This strategy, which benefits from identifying and leveraging market trends, involves clearly defined entry and exit points based on the prevailing market direction.

Szakmary and Lancaster (2015) [28] validate the effectiveness of trend following in the U.S. stock market, demonstrating its potential for generating positive returns. Similarly, research by Blackstar Funds highlights rigorous applications of trend following in commodities, financial futures, and currencies, although its application to stock trading presented challenges. [29]

For day traders, trend following requires rapid execution and diligent risk management, given the shorter time frame and higher transaction costs. Effective day trading using trend following strategies involves real-time trend analysis and the ability to quickly adjust to market changes.

Contrarian investing

Contrarian investing is a market timing strategy used in all trading time-frames. It assumes that financial instruments that have been rising steadily will reverse and start to fall, and vice versa. The contrarian trader buys an instrument which has been falling, or short-sells a rising one, in the expectation that the trend will change. [30]

Range trading

Range trading, or range-bound trading, is a trading style in which stocks are watched that have either been rising off a support price or falling off a resistance price. That is, every time the stock hits a high, it falls back to the low, and vice versa. Such a stock is said to be "trading in a range", which is the opposite of trending. [31] The range trader therefore buys the stock at or near the low price, and sells (and possibly short sells) at the high. A related approach to range trading is looking for moves outside of an established range, called a breakout (price moves up) or a breakdown (price moves down), and assume that once the range has been broken prices will continue in that direction for some time.

Scalping

Scalping was originally referred to as spread trading. Scalping is a trading style where small price gaps created by the bid–ask spread are exploited by the speculator. It normally involves establishing and liquidating a position quickly, usually within minutes or even seconds. [27]

Scalping highly liquid instruments for off-the-floor day traders involves taking quick profits while minimizing risk (loss exposure). [32] It applies technical analysis concepts such as over/under-bought, support and resistance zones as well as trendline, trading channel to enter the market at key points and take quick profits from small moves. The basic idea of scalping is to exploit the inefficiency of the market when volatility increases and the trading range expands. Scalpers also use the "fade" technique. When stock values suddenly rise, they short sell securities that seem overvalued. [33]

Rebate trading

Rebate trading is an equity trading style that uses ECN rebates as a primary source of profit and revenue. Most ECNs charge commissions to customers who want to have their orders filled immediately at the best prices available, but the ECNs pay commissions to buyers or sellers who "add liquidity" by placing limit orders that create "market-making" in a security. Rebate traders seek to make money from these rebates and will usually maximize their returns by trading low priced, high volume stocks. This enables them to trade more shares and contribute more liquidity with a set amount of capital, while limiting the risk that they will not be able to exit a position in the stock. [34]

Trading the news

The basic strategy of trading the news is to buy a stock which has just announced good news, or short sell on bad news. Such events provide enormous volatility in a stock and therefore the greatest chance for quick profits (or losses). Determining whether news is "good" or "bad" must be determined by the price action of the stock, because the market reaction may not match the tone of the news itself. This is because rumors or estimates of the event (like those issued by market and industry analysts) will already have been circulated before the official release, causing prices to move in anticipation. The price movement caused by the official news will therefore be determined by how good the news is relative to the market's expectations, not how good it is in absolute terms.

Price action trading

Price action trading relies on technical analysis but does not rely on conventional indicators. These traders rely on a combination of price movement, chart patterns, volume, and other raw market data to gauge whether or not they should take a trade. This is seen as a "minimalist" approach to trading but is not by any means easier than any other trading methodology. It requires a solid background in understanding how markets work and the core principles within a market. However, the benefit for this methodology is that it is effective in virtually any market (stocks, foreign exchange, futures, gold, oil, etc.).

Market-neutral trading

Market-neutral trading is a strategy that is designed to mitigate risk in which a trader takes a long position in one security and a short position in another security that is related. [27]

Algorithmic trading

It is estimated that more than 75% of stock trades in United States are generated by algorithmic trading or high-frequency trading. The increased use of algorithms and quantitative techniques has led to more competition and smaller profits. [35] Algorithmic trading is used by banks and hedge funds as well as retail traders. Retail traders can buy commercially available automated trading systems or develop their own automatic trading software.

Cost

Commission

Commissions for direct access trading, such as that offered by Interactive Brokers are calculated based on volume, and are usually 0.5 cents per share or $0.25 per futures contract. The more shares traded, the cheaper the commission. Most brokers in the United States, especially those that receive payment for order flow do not charge commissions.

Spread

The numerical difference between the bid and ask prices is referred to as the bid–ask spread. Most worldwide markets operate on a bid-ask-based system.

The ask prices are immediate execution (market) prices for quick buyers (ask takers) while bid prices are for quick sellers (bid takers). If a trade is executed at quoted prices, closing the trade immediately without queuing would always cause a loss because the bid price is always less than the ask price at any point in time.

The bid–ask spread is two sides of the same coin. The spread can be viewed as trading bonuses or costs according to different parties and different strategies. On one hand, traders who do NOT wish to queue their order, instead paying the market price, pay the spreads (costs). On the other hand, traders who wish to queue and wait for execution receive the spreads (bonuses). Some day trading strategies attempt to capture the spread as additional, or even the only, profits for successful trades. [36]

Market data

Market data is necessary for day traders to be competitive. A real-time data feed requires paying fees to the respective stock exchanges, usually combined with the broker's charges; these fees are usually very low compared to the other costs of trading. The fees may be waived for promotional purposes or for customers meeting a minimum monthly volume of trades. Even a moderately active day trader can expect to meet these requirements, making the basic data feed essentially "free". In addition to the raw market data, some traders purchase more advanced data feeds that include historical data and features such as scanning large numbers of stocks in the live market for unusual activity. Complicated analysis and charting software are other popular additions. These types of systems can cost from tens to hundreds of dollars per month to access. [37]

See also

Related Research Articles

<span class="mw-page-title-main">Nasdaq</span> American stock exchange

The Nasdaq Stock Market is an American stock exchange based in New York City. It is the most active stock trading venue in the U.S. by volume, and ranked second on the list of stock exchanges by market capitalization of shares traded, behind the New York Stock Exchange. The exchange platform is owned by Nasdaq, Inc., which also owns the Nasdaq Nordic stock market network and several U.S.-based stock and options exchanges. Although it trades stock of healthcare, financial, entertainment, retail, and food businesses, it focuses more on technology stocks. The exchange is made up of both American and foreign firms, with China and Israel being the largest foreign sources.

<span class="mw-page-title-main">Stock market</span> Place where stocks are traded

A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks, which represent ownership claims on businesses; these may include securities listed on a public stock exchange as well as stock that is only traded privately, such as shares of private companies that are sold to investors through equity crowdfunding platforms. Investments are usually made with an investment strategy in mind.

<span class="mw-page-title-main">Short (finance)</span> Practice of selling securities or other financial instruments that are not currently owned

In finance, being short in an asset means investing in such a way that the investor will profit if the market value of the asset falls. This is the opposite of the more common long position, where the investor will profit if the market value of the asset rises. An investor that sells an asset short is, as to that asset, a short seller.

A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the bid–ask spread, or turn. The benefit to the firm is that it makes money from doing so; the benefit to the market is that this helps limit price variation (volatility) by setting a limited trading price range for the assets being traded.

The Small-Order Execution System (SOES) was a system to facilitate clearing trades of low volume on Nasdaq. It has been phased out and is no longer necessary.

Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of computers relative to human traders. In the twenty-first century, algorithmic trading has been gaining traction with both retail and institutional traders. A study in 2019 showed that around 92% of trading in the Forex market was performed by trading algorithms rather than humans.

A financial quotation refers to specific market data relating to a security or commodity. While the term quote specifically refers to the bid price or ask price of an instrument, it may be more generically used to relate to the last price which this security traded at. This may refer to both exchange-traded and over-the-counter financial instruments.

In finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:

<span class="mw-page-title-main">Stock trader</span> Person or company involved in trading equity securities

A stock trader or equity trader or share trader, also called a stock investor, is a person or company involved in trading equity securities and attempting to profit from the purchase and sale of those securities. Stock traders may be an investor, agent, hedger, arbitrageur, speculator, or stockbroker. Such equity trading in large publicly traded companies may be through a stock exchange. Stock shares in smaller public companies may be bought and sold in over-the-counter (OTC) markets or in some instances in equity crowdfunding platforms.

An order is an instruction to buy or sell on a trading venue such as a stock market, bond market, commodity market, financial derivative market or cryptocurrency exchange. These instructions can be simple or complicated, and can be sent to either a broker or directly to a trading venue via direct market access. There are some standard instructions for such orders.

In finance, a trading strategy is a fixed plan that is designed to achieve a profitable return by going long or short in markets.

A trader is a person, firm, or entity in finance who buys and sells financial instruments, such as forex, cryptocurrencies, stocks, bonds, commodities, derivatives, and mutual funds in the capacity of agent, hedger, arbitrager, or speculator.

Scalping, when used in reference to trading in securities, commodities and foreign exchange, may refer to either

  1. a legitimate method of arbitrage of small price gaps created by the bid–ask spread, or
  2. a fraudulent form of market manipulation.

A commodity broker is a firm or an individual who executes orders to buy or sell commodity contracts on behalf of the clients and charges them a commission. A firm or individual who trades for his own account is called a trader. Commodity contracts include futures, options, and similar financial derivatives. Clients who trade commodity contracts are either hedgers using the derivatives markets to manage risk, or speculators who are willing to assume that risk from hedgers in hopes of a profit.

Trend following or trend trading is a trading strategy according to which one should buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue.

In finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option.

An automated trading system (ATS), a subset of algorithmic trading, uses a computer program to create buy and sell orders and automatically submits the orders to a market center or exchange. The computer program will automatically generate orders based on predefined set of rules using a trading strategy which is based on technical analysis, advanced statistical and mathematical computations or input from other electronic sources.

<span class="mw-page-title-main">Market manipulation</span> Deliberate attempt to interfere with and subvert the free market

In economics and finance, market manipulation is a type of market abuse where there is a deliberate attempt to interfere with the free and fair operation of the market; the most blatant of cases involve creating false or misleading appearances with respect to the price of, or market for, a product, security or commodity.

High-frequency trading (HFT) is a type of algorithmic trading in finance characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. While there is no single definition of HFT, among its key attributes are highly sophisticated algorithms, co-location, and very short-term investment horizons in trading securities. HFT uses proprietary trading strategies carried out by computers to move in and out of positions in seconds or fractions of a second.

Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future —and selling a similar asset forward for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal, and thus one profits by the amount of convergence.

References

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  30. ↑ CHEN, JAMES (May 4, 2018). "Trading Range". Investopedia.
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