What to Buy
Day traders try to make money by exploiting minute price movements in individual assets (stocks, currencies, futures, and options). They usually leverage large amounts of capital to do so. In deciding what to buy—a stock, say—a typical day trader looks for three things:
Liquidity. A security that's liquid allows you to buy and sell it easily, and, hopefully, at a good price. Liquidity is an advantage with tight spreads, or the difference between the bid and ask price of a stock, and for low slippage, or the difference between the expected price of a trade and the actual price.
Volatility. This is a measure of the daily price range—the range in which a day trader operates. More volatility means greater potential for profit or loss.
Trading volume. This is a measure of the number of times a stock is bought and sold in a given time period. It's commonly known as the average daily trading volume. A high degree of volume indicates a lot of interest in a stock. An increase in a stock's volume is often a harbinger of a price jump, either up or down.
When to Buy
Once you know the stocks (or other assets) you want to trade, you need to identify entry points for your trades. Tools that can help you do this include:
Real-time news services: News moves stocks, so it's important to subscribe to services that alert you when potentially market-moving news breaks.
ECN/Level 2 quotes: ECNs, or electronic communication networks, are computer-based systems that display the best available bid and ask quotes from multiple market participants and then automatically match and execute orders. Level 2 is a subscription-based service that provides real-time access to the Nasdaq order book. The Nasdaq order book has price quotes from market makers in every Nasdaq-listed and OTC Bulletin Board security.
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Together, they can give you a sense of orders executed in real time.
Intraday candlestick charts: Candlesticks provide a raw analysis of price action. More on these later.
Define and write down the specific conditions in which you'll enter a position. For instance, buy during uptrend isn't specific enough. Instead, try something more specific and testable: buy when price breaks above the upper trendline of a triangle pattern, where the triangle is preceded by an uptrend (at least one higher swing high and higher swing low before the triangle formed) on the two-minute chart in the first two hours of the trading day.
Once you have a specific set of entry rules, scan more charts to see if your conditions are generated each day. For instance, determine whether a candlestick chart pattern signals price moves in the direction you anticipate. If so, you have a potential entry point for a strategy.
Next, you'll need to determine how to exit your trades.
Deciding When to Sell
There are multiple ways to exit a winning position, including trailing stops and profit targets. Profit targets are the most common exit method. They refer to taking a profit at a predetermined price level. Some common profit target strategies are:
Strategy Description
Scalping Scalping is one of the most popular strategies. It involves selling almost immediately after a trade becomes profitable. The price target is whatever figure means that you'll make money on the trade.
Fading Fading involves shorting stocks after rapid moves upward. This is based on the assumption that (1) they are overbought, (2) early buyers are ready to take profits, and, (3) existing buyers may be scared away. Although risky, this strategy can be extremely rewarding. Here, the price target is when buyers begin stepping in again.
Daily Pivots This strategy involves profiting from a stock's daily volatility. You attempt to buy at the low of the day and sell at the high of the day. Here, the price target is simply at the next sign of a reversal.
Momentum This strategy usually involves trading on news releases or finding strong trending moves supported by high volume. One type of momentum trader will buy on news releases and ride a trend until it exhibits signs of reversal. Another type will fade the price surge. Here, the price target is when volume begins to decrease.
In many cases, you will want to sell an asset when there is decreased interest in the stock as indicated by the ECN/Level 2 and volume. The profit target should also allow for more money to be made on winning trades than is lost on losing trades. If your stop-loss is $0.05 away from your entry price, your target should be more than $0.05 away.
Just as with your entry point, define exactly how you will exit your trades before you enter them. The exit criteria must be specific enough to be repeatable and testable.
Day Trading Charts and Patterns
Three common tools day traders use to help them determine opportune buying points are:
Candlestick chart patterns, including engulfing candles and dojis
Other technical analysis, including trendlines and triangles
Volume
Also, look for signs that confirm the pattern:
A volume spike on the doji candle or the candles immediately following it, which can indicate that traders are supporting the price at this level
Prior support at this price level such as the prior low of day (LOD) or high of day (HOD)
Level 2 activity, which will show all the open orders and order sizes
If you use these three confirmation steps, you may determine whether or not the doji is signaling an actual turnaround and a potential entry point.
Chart patterns also provide profit targets for exits. For example, the height of a triangle at the widest part is added to the breakout point of the triangle (for an upside breakout), providing a price at which to take profits.
How to Limit Losses When Day Trading
Stop-Loss Orders
It's important to define exactly how you'll limit your trade risk. A stop-loss order is designed to limit losses on a position in a security.
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For long positions, a stop-loss can be placed below a recent low and for short positions, above a recent high. It can also be based on volatility.
For example, if a stock price is moving about $0.05 a minute, then you might place a stop-loss order $0.15 away from your entry to give the price some space to fluctuate before it moves in your anticipated direction.
In the case of a triangle pattern, a stop-loss order can be placed $0.02 below a recent swing low if buying a breakout, or $0.02 below the pattern.
You could also set two stop-loss orders:
Place an actual stop-loss order at a price level that suits your risk tolerance. Essentially, this level would represent the most money that you can stand to lose.
Set a mental stop-loss order at the point where your entry criteria would be violated. If the trade takes an unexpected turn, you'll immediately exit your position.
However you decide to exit your trades, the exit criteria must be specific enough to be testable and repeatable.
Set a Financial Loss Limit
It's smart to set a maximum loss per day that you can afford. Whenever you hit this point, exit your trade and take the rest of the day off. Stick to your plan. After all, tomorrow is another (trading) day.
Test Your Strategy
You've defined how you enter trades and where you'll place a stop-loss order. Now, you can assess whether the potential strategy fits within your risk limit. If the strategy exposes you to too much risk, you need to alter it in some way to reduce the risk.
If the strategy is within your risk limit, then testing begins. Manually go through historical charts to find entry points that match yours. Note whether your stop-loss order or price target would have been hit. Paper trade in this way for at least 50 to 100 trades. Determine whether the strategy would have been profitable and if the results meet your expectations.
If your strategy works, proceed to trading in a demo account in real time. If you take profits over the course of two months or more in a simulated environment, proceed with day trading with real capital. If the strategy isn't profitable, start over.
Finally, keep in mind that if you trade on margin, you can be far more vulnerable to sharp price movements. Trading on margin means borrowing your investment funds from a brokerage firm. It requires you to add funds to your account at the end of the day if your trade goes against you. Therefore, using stop-loss orders is crucial when day trading on margin.
Basic Day Trading Techniques
Now that you know some of the ins and outs of day trading, let's review some of the key techniques new day traders can use.
When you've mastered these techniques, developed your own personal trading styles, and determined what your end goals are, you can use a series of strategies to help you in your quest for profits.
Although some of these techniques were mentioned above, they are worth going into again:
Following the trend: Anyone who follows the trend will buy when prices are rising or short sell when they drop. This is done on the assumption that prices that have been rising or falling steadily will continue to do so.
Contrarian investing: This strategy assumes a rise in prices will reverse and drop. The contrarian buys during a fall or short sells during a rise, with the express expectation that the trend will change.
Scalping: This is a style by which a speculator exploits small price gaps created by the bid-ask spread. This technique normally involves entering and exiting a position quickly—within minutes or even seconds.
Trading the news: Investors using this strategy will buy when good news is announced or short sell when there's bad news. This can lead to greater volatility, which can lead to higher profits or losses.
Which Trading Strategy Is Easiest for a Beginner?
Following the trend is probably the easiest trading strategy for a beginner, based on the premise that the trend is your friend. Contrarian investing refers to going against the market herd. You short a stock when the market is rising or buy it when the market is falling. This may be a difficult trading tactic for a beginner. Scalping and trading the news require a presence of mind and rapid decision-making that, again, may pose difficulties for a beginner.
Is Technical Analysis or Fundamental Analysis More Appropriate for Day Trading?
Technical analysis can be more appropriate for day trading. That's because it can help a trader to identify the short-term trading patterns and trends that are essential for day trading.
Fundamental analysis is better suited for long-term investing, as it focuses on valuation. The difference between an asset's actual price and its intrinsic value as determined by fundamental analysis may last for months, if not years. Market reaction to fundamental data like news or earnings reports is also quite unpredictable in the short term.
That said, market reaction to such fundamental data should be monitored by day traders for trading opportunities that can be exploited using technical analysis.
Why Is It Difficult to Make Money Consistently From Day Trading?
Making money consistently from day trading requires a combination of many skills and attributes—knowledge, experience, discipline, mental fortitude, and trading acumen.
It's not always easy for beginners to implement basic strategies like cutting losses or letting profits run. What's more, it's difficult to stick to one's trading discipline in the face of challenges such as market volatility or significant losses.
Finally, day trading involves pitting wits with millions of market pros who have access to cutting-edge technology, a wealth of experience and expertise, and very deep pockets. That's no easy task when everyone is trying to exploit inefficiencies in efficient markets.
Should a Day Trading Position Be Held Overnight?
A day trader may wish to hold a trading position overnight either to reduce losses on a poor trade or to increase profits on a winning trade. Generally, this is not a good idea if the trader simply wants to avoid booking a loss on a bad trade.
Risks involved in holding a day trading position overnight may include having to meet margin requirements, additional borrowing costs, and the potential impact of negative news. The risk involved in holding a position overnight could outweigh the possibility of a favorable outcome.
The Bottom Line
Day trading is difficult to master. It requires time, skill, and discipline. Many who try it lose money, but the strategies and techniques described above may help you create a potentially profitable strategy.
Day traders, both institutional and individual, play an important role in the marketplace by keeping the markets efficient and liquid. With enough experience, skill-building, and consistent performance evaluation, you may be able to improve your chances of trading profitably.
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