In its simplest form, day trading involves buying and selling a security within the same day. In reality, many day traders make multiple trades per day, sometimes in numerous securities.
The explosion of day trading seems inevitable in retrospect. First, most of the major online brokerage houses went to a $0 commission policy on stocks and ETFs. Next, the proliferation of online message boards has made it easy for traders to communicate ideas to one another. While the press is full of stories about day traders who have made a killing, it’s not often reported that many day traders lose money. Before you dive into this risky trading strategy, you should understand these dangers of day trading.
Let’s get this one out of the way right off the bat. Although the life of a day trader may seem easy and glamorous, the truth is that it’s hard even for professional money managers to beat the stock market. In fact, 2020 marked the 11th straight year that professional large-cap mutual fund managers failed to beat the market, with 60% underperforming. According to the Social Science Research Network, a study of Brazilian day traders found that 97% of traders in the market for more than 300 days lost money, and only 1.1% ended up profitable. These statistics no doubt could translate to the U.S. market as well. The bottom line is that as exciting as day trading seems, the risk to traders — particularly novice ones — is large.
Leaving Gains on the Table
Short-term movements in individual stock prices can be remarkable, but they are for the most part unpredictable. However, the long-term movements of the stock market are anything but unpredictable. This may be surprising, given the volatility in the stock market, but there has never been a 20-year rolling period in which the S&P 500 stock market has lost money. When day traders move in and out of stocks rapidly, they have no chance of capturing the long-term upside bias of the stock market. Large gains can be made within a single day, but the risk/reward ratio in the stock market favors the long-term investor.
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Day traders face enough of an uphill climb just making profits on their frequent trades. But even if you’re good enough or lucky enough to make profitable day trades, you’ll have to factor in the effects of taxes to determine your ultimate profitability. As a short-term trader, any profits you take will be taxed as a short-term capital gain, meaning you’ll pay your ordinary income tax rate on your profits. If you’re in a high tax bracket, your combined federal and state tax rates could be 45% or more. Long-term capital gains taxes, on the other hand, can be as low as 0% depending on your tax bracket. This makes holding your investments for longer than one year significantly less taxing.
High Transaction Costs
This danger has become less of a burden in recent years, thanks to the proliferation of $0-commission brokers. However, frequent trading can still carry high transaction costs. Obviously, for brokers without a $0-commission structure, fees and trading costs can easily eat away any profits you make. Most large firms with standard commission structures can still charge hundreds of dollars per trade. But even at low-cost brokers, trades can trigger SEC and FINRA transaction fees. Granted, these fees are quite small, just fractions of a penny per sale. However, for active traders, they can add up over time. Some firms may also slap day traders with excessive trading fees, so do your homework to find the full cost of your trading before you begin.
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Lack of Disciplined Strategy
Professional day-trading firms have complex computer algorithms and strict investment rules in place to maximize their profitability. Most home-based day traders, however, simply buy and sell stocks that they like. While this can work over the short term, it’s not a viable long-term strategy for a day trader. If you’re going to improve your chances to make money day trading, you’ll need to implement buy and sell strategies and adhere to them. Without defining parameters of when to get into and out of stocks, day traders can get burned.
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What can be a fun sideline with play money can turn downright stressful when using real money. If you’re day trading with your retirement money, or with money you’ve saved for a down payment for a house, the stress level could be crippling. To make these types of trades over and over on a daily basis only compounds the stress level. The bottom line is that even if you’re using discretionary “play money” to day trade, losing on repeated trades will still punch up your stress level. If you’re going to make day trading a regular thing, you’ve got to be prepared to handle this excess stress.
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Limitations on Trading
Most major brokerages prohibit what’s known as “pattern day trading.” A pattern day trader is someone who exhibits the characteristics of frequent day trading. Even at online platform Robinhood, one of the pioneers of $0-commission trading and a home for day traders, pattern day trading restrictions can be enforced. At Robinhood, these restrictions can be avoided by having at least $25,000 in your account, but individual brokerage firms may have different requirements. Before you embark on a career in day trading, check to see what the limitations of your firm may be.
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Being a day trader means relying on your technology every moment of every day. If your computer is slow, if there’s a power outage, if there’s a glitch in your internet, a profitable trade can rapidly turn into a loser while you’re frantically trying to log on. Even if your technology setup at home is rock solid, your broker’s website might go down, leaving you with no way to make your trades. Perhaps the most notorious such outage occurred at online broker Robinhood in the midst of the pandemic-induced stock market volatility in March 2020. On Monday, March 2 of that year, a Robinhood outage prevented traders from participating in the biggest one-day point gain in Dow Jones Industrial Average history at the time. Missing big days like that on the upside can be catastrophic for day traders, as can being unable to blow out of positions when the market is selling off.
Knowing Just Enough To Be Dangerous
There’s an old expression on Wall Street that refers to some traders as “knowing just enough to be dangerous.” What this means is that some traders have learned how to make trades and how to find hot stocks, but they don’t know enough about how the market works as a whole or how to have a rock-solid investment strategy. Many, if not most, amateur day traders likely fall into this category. As day trading has become easier and more inexpensive than ever, more and more true amateurs have entered the field. And as the investment world is one that can lay waste to even professional traders with decades of experience, those who know just enough to get started can find themselves in dangerous waters fast. Investors in this camp would be wise to do some research on what’s known on Wall Street as the “pain trade,” which refers to the market’s tendency to move in ways that would cause the most pain to the most people possible.
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Missing Out on What You’re Investing In
This “danger” is a bit more philosophical, but for market purists, it’s still an important one. To a day trader, a stock is simply a number on a screen or a mark on a chart. But in reality, shares of stock represent ownership in an actual, physical company. When an investor buys a share of stock in Facebook, for example, that purchase represents an investment in the growth of that very well-known company. Long-term investors often feel pride in supporting and participating in the story of a real company, tracking the news that surrounds the business and getting excited for future opportunities as they are announced. That feeling is something that day traders, who swap in and out of stocks in the pursuit of pure profit, definitely miss out on.