Few approaches to stock trading garner the sort of persistent fascination that day trading does. Day traders are speculators who buy and sell stocks or other financial instruments within the same trading day in an attempt to reap profits from the constantly shifting prices.
Day trading is not illegal, but it is extremely risky and rarely results in profits. Even compared to other notoriously volatile enterprises like penny stock trading, day trading is less likely to result in success and less profitable when it does. Despite this, many people still think they can beat the odds or just want to chase the thrilling moment-to-moment action.
So if you want to know how to day trade stocks, here’s a look at some day trading tips and rules to help you get started.
1. Don’t Do It
Just don’t. Day trading is, generally speaking, a really bad idea — particularly if your end goal is to make money. There’s a reason the only people suggesting day trading are typically people selling classes or books about it: Selling classes and books is one of the only ways to consistently turn a profit. A 2011 study by the University of California, Berkeley found that just 13 percent of day traders turn a profit in a given year and just 1 percent are able to profit consistently year over year.
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“You will be competing against professionals who use the latest technology, co-located servers and immediate news aggregation services,” said Dejan Ilijevski, president of Sabela Capital Markets and a former day trader. “Even with these advantages, most fail.”
If you’re interested in day trading because it sounds exciting and the money isn’t important to you, it could be a fun but extremely risky hobby. But if you’re looking for a source of income or a way to grow your retirement account, remember the first rule of day trading: Don’t do it.
2. Know the Lingo
So, day trading is extremely risky and you will almost certainly lose money, but if you really, really must start day trading, you should understand some key terminology:
- Leverage: Increasing the money behind a given trade to maximize the potential returns created
- Margin trading: Borrowing money — usually from your broker — and using that money to speculate on financial markets
- Entry point: The price at which you purchase the stock or other instrument you’re trading
- Exit point: The price at which you sell, exiting the position
- Bid-ask system: The basic system for the buying and selling of stocks and other securities; anyone interested in buying a stock enters a “bid” — the price they want to pay — while anyone wishing to sell a stock enters an “ask,” or the price they want to sell at
- Market order: An order for a stock trade that is to be executed at the prevailing market price
- Limit order: An order for a stock trade that will only be executed at the bid or ask price included in the order
3. You Need at Least $25,000
The Financial Industry Regulatory Authority (FINRA) requires that anyone engaged in day trading maintain at least $25,000 in their brokerage account, known as the “pattern day trader” rule. If you buy and sell a stock or other security within the same day more than four times in a week, you’ll be considered a day trader and need to meet the rule’s requirements.
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This rule also reflects another important reality: You need a lot of money to day trade. Most trades will involve relatively slim margins — especially after fees — so you need to put a lot of money behind them to turn a substantial profit. That’s why beginners should use a stock trading simulator prior to putting actual cash behind their efforts.
3. Expect to Do Margin Trading …
Because day traders turn a very small gain, if any, for each share they trade, they need leverage to buy up more shares — usually in the form of margin trading. By borrowing from your broker, you can double the size of your trade. That’s the cap, though, as Regulation T from the Federal Reserve Board mandates you can only borrow up to half of the purchase price of the securities.
Margin trading comes with incredible risk, however. Although borrowing the maximum means quadrupling profits when you succeed, it also means quadrupling losses when you don’t, which can quickly push you deep into debt with your broker. You’ll also pay interest on any money you borrow just like any other loan.
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4. … or Options Trading
One other way to get leverage is through options — contracts that allow you to buy or sell a stock or other security or commodity at a particular price in the future. Because the price of the contracts is much lower than the price of stock, you can buy contracts that represent many more shares than you could otherwise afford.
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Stock options trading has different risks from other stock market trading, though. Options contracts that don’t get “in the money” are worthless, so a failed trade often involves losing everything you put behind it. Success usually magnifies your potential returns considerably, however, and unlike margin trading, you aren’t in danger of losing borrowed money. Regardless, options can be very complex and should be extensively researched before use.
5. Short-Term Investing Means Higher Taxes
The capital gains tax is a lower tax rate on income derived from selling investments or other assets. Jumping in and out of stocks or other securities to try and profit from short-term price swings, however, is not investing — it’s speculating — and the tax code reflects that.
Anything you own for less than a year — i.e., everything for day traders — isn’t subject to the lower rate, so you’ll pay the normal, higher income tax rate on any profits.
6. Build a Strategy
One of the biggest mistakes made by novice traders is trying to “read” the market — improvising to try to ride swings in momentum. Most veteran traders, though, will tell you that one of the most important elements of successful trading is nailing down a clear, executable strategy ahead of time and following it carefully.
“Trading can’t be done based on emotion — it has to be based on a specific rule set and trading plan,” said Danielle Shay Gum, a technical analyst at Simpler Trading.
Before you trade, you should have a clear sense of your planned entry point, exit point and stops. Better still, if your online stock trading software has the option to automate your trades, you can be sure your emotions won’t drive you to make mistakes.
7. Always Use Limit Orders
Your strategy should be built around very specific stock trading information about the sort of patterns that emerge in the way a particular stock trades, so it’s important to have a precise sense of what price you want to buy and sell at. Market orders can easily end up executing at a different price from where stocks are trading when you enter them, so the best plan is to stick to limit orders that will only execute on your terms.
Hypothetical Day Trading Examples
You’ve set up your brokerage account, funded it with $25,000 and made sure you’re set up to trade on margin. You’ve also been carefully watching the trading patterns for shares in Corporation XYZ — a niche tile supplier to Scrabble-maker Hasbro — to become familiar with what to expect.
At 10 a.m., you see that the stock is trading at just $10, falling from $15 at the start of the day. You think that’s low, so you enter a limit order to purchase shares at $10. Before you do, though, you set up parameters to sell automatically if the price drops below $5 — the most you’re ready to lose — or reaches $20, the highest price you think the stock will realistically climb to.
Now, if you just used the $25,000 in your account, you could buy 2,500 shares of stock. If you use maximum leverage, however, you can borrow $25,000 on margin to buy an additional 2,500 shares. You feel confident, based on your research and observations, so you decide to take the risk and margin trade.
Scenario 1: You were right! The price quickly reverses and starts rising. It hits $20 a share by noon, and your software automatically exits the position with you up $50,000 — minus any fees or commissions — on the trade. You celebrate with a new car.
Scenario 2: You were wrong! The price stabilizes briefly, then keeps falling. By the end of the day, it’s trading at $6 a share, so you have to cash out for just $30,000. However, $25,000 of that is owed to your broker — plus any fees or commissions — so you’re left with less than $5,000 after paying back your margin loan. You have to sell your car.
If you like the sound of high-risk investments, proceed with caution. If you’re convinced this isn’t the right investment option for you, discuss stock market investment options suitable for you with a financial advisor or consider ways to invest that don’t involve the stock market.