What Is Day Trading? Your Guide to Starting
Day traders get their name from their style of investing. Instead of buying and holding, as per the advice of investment experts everywhere, they do the exact opposite. Day trading involves buying securities only to sell them a short time later–usually within a single trading day–in the hopes of locking in relatively small short-term gains that accumulate and compound over time.
It’s a risky game defined by big profits and steep losses. Retail investors–regular, nonprofessional, individual investors without access to corporate resources and research–rarely make money consistently over time. The lure, however, is simply too much to resist for some.
Despite the long odds of success, the idea of ditching your 9-to-5 and financing your lifestyle just by moving numbers around on a computer screen a few hours a day is too enticing to pass up for many. If you’re considering entering the risky but exciting world of day trading, here’s what you need to know.
What Is Day Trading?
Day trading refers to the buying and selling of stocks over an extremely short time frame. A day trader will rarely hold a position overnight, and this holding period can be as short as a few minutes or even a few seconds. The idea behind day trading is that very small profits can be garnered in a very short time span, without putting large amounts of capital at risk.
As soon as a position turns negative, most day traders are out. similarly, as soon as a profit is generated, most traders typically sell. The term “day trading” can apply to both short sales and the traditional buying and selling of stocks.
One related alternative to day trading is swing trading, in which investments are held for a few days or weeks. Traditional “buy-and-hold” investors, on the other hand, maintain positions for months or years. The logic of buying and holding is that the inevitable short-term losses will be negated by long-term gains over time–but only for investors who resist the urge to sell when a stock starts losing value.
For novices and even moderately experienced investors, long-term investing is the most widely recommended strategy by far–and for good reason. Unlike day trading, the common investor can make buy-and-hold investing work with a little bit of research and luck.
Publications like Forbes have reported a steep rise in day trading as free brokerage accounts and an incredible amount of research materials are now available to just about everyone with a laptop. Many financial professionals, who tend to look at day trading as gambling more than investing, see it as a disaster in the making.
How To Start Day Trading
- M1 Finance
You should plan, however, to face additional restrictions once you get going. For starters, if you’re flagged as a “pattern day trader,” you’ll be required to open a margin account.
Trading on Borrowed Money Increases the Risk
A margin account is a special type of brokerage account in which the account holder borrows money from the brokerage firm to purchase securities. It’s a whole new world. Although margin accounts allow investors to cash in when the stocks they buy on the margin appreciate, margin loans come with interest.
That means that losses are magnified dramatically compared to regular stock purchases because the borrower has to pay not only to make up for the losses on borrowed money but also to pay the interest charges.
You Have to Pay to Play
According to the Financial Industry Regulatory Authority, a pattern trader is “any margin customer that day trades — buys then sells, or sells short then buys the same security on the same day — four or more times in five business days, provided the number of day trades is more than 6% of the customer’s total trading activity for that same five-day period.”
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Once you acquire this label, day trading rules require you to maintain a minimum account balance of at least $25,000. If your account falls below $25,000, you’ll be restricted from making day trades and receive a margin call, which requires you to deposit more cash to meet the call.
Consider Starting With a Practice Run
Day trading is tricky, unfamiliar, and for most, it comes with a steep learning curve. Experts strongly–and wisely–advise newbies to start with a practice account where they can hone their skills in simulated day trading before they dive into the deep end of the pool without risking actual money.
You’re probably eager to get started in your new career making millions in your pajamas, but the learning experience of simulated, no-risk day trading can prove invaluable. If you’ve never done it before, you’ll need the practice. Some of the top day trading simulators include:
Day Trading Taxation
If you can qualify with the IRS as a professional trader, you can deduct any expenses related to your trading, such as computers, software, home office expenses and others. You can also make a “mark-to-market” tax election that can help you avoid tax traps such as wash sales.
Bear in mind that most amateurs cannot qualify as traders under strict IRS rules. In the end, it’s all about capital gains–short-term gains like those earned by successful day traders are taxed at a much higher rate than long-term gains.
Day Trading Tips
Successful day traders lead enviable lives. No job. No boss. No schedule. No commute. The life also, however, offers no security or retirement plan beyond the next trade. If you’re ready to take the plunge, the following tips can get you off on the right foot.
Understand What You’re Up Against
Whenever you buy or sell stocks, there’s a trader out there betting against you by taking the other side of your trade. As a day trader, this other party is likely to be a computer algorithm or a well-funded institution.
In short, you’re competing with professionals in a highly competitive and crowded field. They’re often competing for fractions of a penny per trade against other skilled pros. Just like card sharks at a poker table, the regulars salivate when a newbie joins the game.
Understand the Risks
One of the best things you can do is avoid going into it with illusions or delusions about the realities of day trading. If most people could earn a living day trading, most people would be day traders. The reality, according to CNBC and virtually all available data, is that you’re facing overwhelming odds.
Even buy-and-hold investors underperform the market 85% of the time when picking individual stocks. When it comes to pattern day traders, that number shrinks to a minuscule percentage of retail investors who make money consistently over time.
Although YouTube is full of videos of “experts” ready to reveal the simple tips and tricks any novice can use to turn $1 into $1 million in no time flat, remember the adage: if it sounds too good to be true, it probably is.
Good To Know
NPR profiled a day trader who lost his entire six-figure savings incredibly quickly as losses rapidly snowballed out of control. He tried to compensate by chasing gains, only to lose more–all on borrowed margin money, no less–until there was nothing left. This familiar scenario is much closer to the rule and the successful amateur day trader is undoubtedly the exception.
If You’re Going to Do It, Do It All the Way
There is widespread expert consensus that day trading is a losing gamble for average investors, virtually all of whom would be better off sinking their money into an index fund. All experts, however, seem to agree that you stand essentially no chance if you treat it like a hobby.
The tiny percentage of amateur day traders who succeed over time have one thing in common: they treat it like a full-time job. If you dabble here and there, you’re essentially guaranteeing a loss. No matter how seriously you take it, never day trade with money you can’t afford to lose.
John Csiszar contributed to the reporting for this article.
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- Forbes. 2020. "Day Trading Surges In Popularity, This Won't End Well."
- Robinhood. "Robinhood."
- Forbes. 2020. "Cash Account vs Margin Account: Which Do I Need?"
- FINRA. "Day-Trading Margin Requirements: Know the Rules."
- Corporate Finance Institute. "Mark to Market - Overview, Importance, Practical Example."
- Wealthfront. 2020. "Day Trading? Don't Forget About Taxes."
- CNBC. 2020. "Attention Robinhood power users: Most day traders lose money CNBC."
- NPR. 2020. "He Thought Day-Trading Would Be a Thrill. He Ended Up Losing."