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An Introduction To Day Trading

Day trading is defined as the buying and selling of a security within a single trading day. Typically, day traders are well educated and well funded. They utilize high amounts of leverage and short-term trading strategies to capitalize on small price movements in highly liquid stocks or currencies. Day traders serve two critical functions in the marketplace: they keep the markets running efficiently via arbitrage and they provide much of the markets' liquidity (especially in the stock market). This article will take an objective look at day trading, who does it and how it is done.

The Controversy

Search "day trading" on Google and you will see why there is controversy! The profit potential of day trading is perhaps one of the most debated (and misunderstood) topics on Wall Street. Countless internet scams have capitalized on this confusion by promising enormous returns in a short period. Meanwhile, the media continues to promote this type of trading as a get-rich-quick scheme that always works. The truth lies somewhere in the middle. There are those who engage in this type of trading without sufficient knowledge, or some even admittedly for a gambler's high; however, there are day traders who are able to make a successful living.

Many professional money managers and financial advisors shy away from day trading, arguing that in most cases the reward does not justify the risk. They often cite that no day trader is world renown, whereas icons like Warren Buffett and Peter Lynch are a testament to the success that can be attained by more traditional forms of investing. Conversely, those who do day trade insist there is profit to be made. They say the success rate is inherently lower as a result of the higher complexity and necessary risk of day trading, combined with all the related scams.

Overall, the street remains divided on the issue. At the very least they agree that day trading is not for everyone and involves significant risks. Moreover, it demands an in-depth understanding of how the markets work and various strategies for profiting in the short term. Now we'll take a look at the various aspects of day trading.

Characteristics of a Day Trader

This article will focus on professional day traders - that is, those who trade for a living, not simply as a hobby or for a "gambling high." These traders are typically well-established in the field and have in-depth knowledge of the marketplace. Here are some of the prerequisites to day trading:

  • Knowledge and Experience in the Marketplace: Individuals who attempt to day trade without an understanding of market fundamentals often end up losing money.

  • Sufficient Capital: One cannot expect to make money day trading. Day traders use only risk capital, which they can afford to lose. Not only does this protect them from financial ruin, but it also helps eliminate emotion from their trading. A large amount of capital is often necessary to capitalize effectively on intra-day price movements.

  • A Strategy: A trader needs an edge over the rest of the market. There are several different strategies that day traders utilize, including swing trading, arbitrage and trading news, among others. These strategies are refined until they produce consistent profits and effectively limit losses.

  • Discipline: A profitable strategy is useless without discipline. Many day traders end up losing a lot of money because they fail to make trades that meet their own criteria. As they say, "Plan the trade and trade the plan." Success is impossible without discipline.

Day Trading for a Living
There are two primary divisions of professional day traders: those who work alone and/or those who work for a larger institution. Most day traders who trade for a living work for a large institution. The fact is these people have access to things individual traders could only dream of: a direct line to a dealing desk, large amounts of capital and leverage, expensive analytical software and much more. These traders are typically the ones looking for easy profits that can be made from arbitrage opportunities and news events. The resources to which they have access allow them to capitalize on these less risky day trades before individual traders can react.

Individual traders often manage other people's money or simply trade with their own. Few of them have access to a dealing desk; however, they often have strong ties to a brokerage (due to the large amounts of commission spending) and access to other resources. However, the limited scope of these resources prevents them from competing directly with institutional day traders; instead, they are forced to take more risks. Individual traders typically day trade using technical analysis and swing trades - combined with some leverage - to generate adequate profits on such small price movements in highly liquid stocks.


Day trading demands access to some of the most complex financial services and instruments in the marketplace. Day traders require:

  • Access to the Trading Desk: This is usually reserved for traders working for larger institutions or those who manage large amounts of money. The dealing desk provides these traders with instantaneous order executions, which can become important, especially when sharp price movements occur. For example, when an acquisition is announced, day traders looking at merger arbitrage can get their orders in before the rest of the market, taking advantage of the price differential.

  • Multiple News Sources: In the movie "Wall Street" Gordon Gekko says that "information is the most important commodity when trading." News provides the majority of opportunities day traders capitalize on, so it is imperative to be the first to know when something big happens. The typical trading room contains access to the Dow Jones Newswire, televisions showing CNBC and other news agencies, as well as software that constantly analyzes various other news sources for important stories.

  • Analytical Software: Trading software is an expensive necessity for most day traders. Those who rely on technical indicators or swing trades rely more on software than news. This software typically contains many features, including:
    • Automatic pattern recognition - This means that the trading program identifies technical indicators like flags, channels and even more complex indicators like Elliott Wave patterns.
    • Genetic and neural applications - These are programs that utilize neural networks and genetic algorithms to perfect trading systems to make more accurate predictions of future price movements.
    • Broker integration - Some of these applications even interface directly with the brokerage, which allows for instantaneous and even automatic execution of trades. This is helpful for eliminating emotion from trading and improving execution times.
    • Back testing - This allows traders to look at how a certain strategy would have performed in the past in order to predict more accurately how it will perform in the future (although past performance is not always indicative of future results).

Combined these tools provide traders with an edge over the rest of the marketplace. It is easy to see why, without them, so many inexperienced traders lose money.

The Bottom Line

Although day trading has become somewhat of a controversial phenomenon, its prevalence is undeniable. Day traders, both institutional and individual, play an important role in the marketplace by keeping the markets efficient and liquid. Some argue that individuals should stay away from day trading, while others argue that it is a viable means to profit. Although it is becoming increasingly popular among inexperienced traders, it should be left primarily to those with the skills and resources needed to succeed.

Day Trading Strategies For Beginners

When people use the term "day trading", they mean the act of buying and selling a stock within the same day. Day traders seek to make profits by leveraging large amounts of capital to take advantage of small price movements in highly liquid stocks or indexes. Here we look at some common day trading strategies that can be used by retail traders.

Entry Strategies
Certain stocks are ideal candidates for day trading. A typical day trader looks for two things in a stock: liquidity and volatility. Liquidity allows you to enter and exit a stock at a good price (i.e. tight spreads and low slippage). Volatility is simply a measure of the expected daily price range - the range in which a day trader operates. More volatility means greater profit or loss.

Once you know what kinds of stocks you are looking for, you need to learn how to identify possible entry points. There are three tools you can use to do this:

  • Intraday Candlestick Charts - Candles provide a raw analysis of price action.
  • Level II Quotes/ECN - Level II and ECN provide a look at orders as they happen.
  • Real-Time News Service - News moves stocks. This tells you when news comes out.
We will look at the intraday candlestick charts and focus on the following three factors:

  • Candlestick Patterns - Engulfings and dojis
  • Technical Analysis - Trendlines and triangles
  • Volume - Increasing or decreasing volume
There are many candlestick setups that we can look for to find an entry point. If properly used, the doji reversal pattern (highlighted in yellow in Figure 1) is one of the most reliable ones.

Figure 1: Looking at candlesticks - the highlighted doji signals a reversal.
Typically, we will look for a pattern like this with several confirmations:
  • First, we look for a volume spike, which will show us whether traders are supporting the price at this level. Note that this can be either on the doji candle, or on the candles immediately following it.
  • Second, we look for prior support at this price level. For example, the prior low of day (LOD) or high of day (HOD).
  • Finally, we look at the Level II situation, which will show us all the open orders and order sizes.
If we follow these three steps, we can determine whether the doji is likely to produce an actual turnaround, and we can take a position if the conditions are favorable. Typically, entry points are found using a combination of these three tools.

Finding a Target
Identifying a price target will depend largely on your trading style. Here is a brief overview of some common day trading strategies:

Scalping is one of the most popular strategies, which involves selling almost immediately after a trade becomes profitable. Here the price target is obviously just after profitability is attained.
Fading involves shorting stocks after rapid moves upwards. This is based on the assumption that (1) they are overbought, (2) early buyers are ready to begin taking profits and (3) existing buyers may be scared out. 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. This is done by attempting to buy at the low of the day (LOD) and sell at the high of the day (HOD). Here the price target is simply at the next sign of a reversal, using the same patterns as above.
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. The other type will fade the price surge. Here the price target is when volume begins to decrease and bearish candles start appearing.

You can see that, although the entries in day trading strategies typically rely on the same tools used in normal trading, the exits are where the differences occur. In most cases, however, you will be looking to exit when there is decreased interest in the stock (indicated by the Level II/ECN and volume).

Determining a Stop-Loss
When you trade on margin, you are far more vulnerable to sharp price movements than regular traders. Therefore, using stop-losses is crucial when day trading. One strategy is to set two stop losses:

1. A physical stop-loss order placed at a certain price level that suits your risk tolerance. Essentially, this is the most you want to lose.
2. A mental stop-loss set at the point where your entry criteria are violated. This means that if the trade makes an unexpected turn, you'll immediately exit your position.

Retail day traders usually also have another rule: set a maximum loss per day that you can afford (both financially and mentally) to withstand. Whenever you hit this point, take the rest of the day off. Inexperienced traders often feel the need to make up losses before the day is over and end up taking unnecessary risks as a result.

Evaluating and Tweaking Performance
Many people get into day trading expecting to make triple digit returns every year with minimal effort. In reality, many day traders lose money. However, by using a well-defined strategy that you are comfortable trading, you can improve your chances of beating the odds.

How do you evaluate performance? Most day traders evaluate performance not so much by a percentage of gain or loss, but rather by how closely they adhere to their individual strategies. In fact, it is far more important to follow your strategy closely than to try to chase profits. By keeping this mindset, you make it easier to identify where problems exist and how to solve them.

The Bottom Line
Day trading is a difficult skill to master. As a result, many of those who try it fail. But the techniques described above can help you create a profitable strategy and, with enough practice and consistent performance evaluation, you can greatly improve your chances of beating the odds.

5 Rules For Picking Great Day Trade Entries

Day trading involves isolating the current trend from market noise and then capitalizing on that trend through well-timed entries and profit taking. These factors play a crucial role in managing potential profit expectations and risk. Trading has many challenges, but by sticking to certain guidelines success is more likely. Since the market always moves in waves, on all time frames, rules can be created for exploiting this phenomenon. The following five rules will help traders find high profit potential, low risk, intra-day trades.

1. Trade only with the current intra-day trend
Trading with the trend allows for low risk entries and high profit potential if the trend continues. Intra-day trends do not continue indefinitely, reversals do occur, but usually one or two trades, and sometimes more, can be made before the trend reverses.

Isolating the trend can be the difficult part. Trendlines provide a very simple and useful entry and stop loss strategy. Focus on trading with the dominant trend of the day. When that trend shifts, begin trading with the new trend. Figure 1 shows several short-term trends during a typical day.

Figure 1. SPY with Trendlines – 1 Minute
Source: Free Stock Charts

More trendlines can be drawn when trading in real time, for the varying degrees of each trend. Drawing in more trendlines can provide more signals and also can provide greater insight into the changing market dynamics.

2. Trade strong stocks in an uptrend, weak stocks in a downtrend
Most traders will find it beneficial to trade stocks or ETFs that have at least a moderate to high correlation with the S&P 500, Dow or Nasdaq indexes. By trading stocks or ETFs with a high correlation to the major indexes, stocks that are relatively weak or strong, compared to the index, can be isolated. This creates an opportunity for the day trader, as he or she can isolate which stocks are likely to provide a better return, given the movement of individual stocks relative to the index.

When the indexes/market futures are moving higher, traders should look to buy stocks that are moving up more aggressively than the futures. When the futures pull back, a strong stock will not pull back as much, or may not even pull back at all. These are the stocks to trade in an uptrend, as they lead the market higher and thus provide more profit potential and lower risk; smaller pullbacks mean less risk.

When the indexes/futures are dropping, short sell stocks that drop more than the market. When the futures move higher within the downtrend, a weak stock will not move up as much, or will not move up at all. Weak stocks are less risky when in a "short" position and provide great profit potential when the market is falling.

Which stocks and ETFs are stronger or weaker than the market can change daily, although certain sectors may be relatively strong or weak for weeks at a time.

Figure 2 shows SPY, the S&P 500 ETF, compared to XOP, the Oil Exploration and Production ETF. XOP (blue line) was relatively strong compared to the SPY, especially on market rallies. Overall the market moved higher throughout the day, and because XOP had such large gains on rallies, it was a market leader and outperformed SPY on a relative basis throughout the day.

Figure 2. SPY vs. XOP – 2 Minute, August 31, 2011
Source: Free Stock Charts

3. Be patient - wait for the pullback
Trendlines help to show how the market moves in waves. Trendlines are an approximate visual guide to where waves in price will begin and end. Therefore, we can use a trendline for early entry into the next price wave in the direction of the trend.

When entering a long position, buy after the price moves down toward the trendline and then moves back higher. To draw the trend line, a price low and then a higher price low will be needed. The line is drawn connecting these two points and then extended out to the right. Figure 3 shows how XLF, the SPDR Financial Sector ETF, bounced off its trendline twice, providing two potential trade opportunities by being patient and waiting for the pullback in the trendline to occur.

Figure 3. XLF - 1 Minute Chart, November 4, 2011
Source: Free Stock Charts

Short selling in a downtrend would be similar. Wait until the price moves up the downward sloping trendline, then when the stock begins to move back down, this is when the entry is made.

By being patient, these two long trades provide a very low risk entry, as the purchase is made close to the stop level, which could be several cents below the trendline.

4. Take profits
Since markets move in waves, we want to exit before a correction occurs. Day traders have limited time to capture profits and must therefore spend as little time as possible in trades that are losing money or reducing "paper profits" to a substantial degree. When a trade is entered, if it becomes profitable, but the profit is unrealized, it is a called a "paper profit." Day traders want to turn paper profits into real profits before the trend reverses on them.

There are two very simple rules that can be used to take profits when trading with trends.

  • In an uptrend or long position, take profits at or slightly above the former price high in the current trend.
  • In a downtrend or short position, take profits at or slightly below the former price low in the current trend.

Figure 4 shows the same XLF chart exemplified earlier. This time entries and exits are marked. The chart shows that as the trend continues higher the price pushes through past highs, which provide an exit for each respective long position taken. Since markets do make double tops, or the price may meet resistance at an old price high, profits can be taken at the same price as the former high, as well. The same method can be applied to downtrends; profits are taken at or slightly below the prior price low in the trend.

Figure 4. XLF – 1 Minute Chart, November 4, 2011-11-06
Source: Free Stock Charts

5. When the market reverses, step aside
Markets don't always trend. Intra-day trends can also reverse so often that an overriding direction is hard to establish. If major highs and lows are not being made, make sure the intra-day movements, which will be within a range, are large enough for the potential reward to exceed the risk.

If there are periods where prices move in a horizontal price range, step aside and don’t trade. Alternatively, switch to a range trading type strategy. If switching to a range trading strategy, all the rules still apply. The overall trend does not exist, but is actually a range. Wait for the price to reach near the high of the range and then turn back lower. This will provide a low risk entry and the trade is exited at, or near, the low of the range. The same method can be applied to long entries within a range.

When low risk entries are not present or clearly visible, step aside and do not trade.

The Bottom Line
Day traders should trade with the overall trend and patiently wait for low risk entries to potentially profit from that trend. Trendlines can be used as a guide to help traders determine these low-risk entry points, as well provide potential stop levels. Buying stocks that are stronger than the index in uptrends and shorting stocks that are weaker than the index in downtrends should provide more safety and relative outperformance profits. Profits must be realized and should be taken at or above the prior price high in an uptrend. Conversely, they should be taken at or below the prior price low in a downtrend. Do no trade when the trend is unclear. If a well defined range develops, this may be traded by using a low risk range trading strategy.