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Day Trading: How It Works and What Is Required to Become Good

written by: Steve McFarlane•edited by: Michele McDonough•updated: 7/14/2011

Day trading is a popular strategy used to profit from the stock, forex and commodity markets. In part, it is growing in popularity because it allows for quick profits to be made from the smallest price movements. Is it a good strategy for you?

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    Short Term vs. Long Term

    What's Your Trading Strategy? Some of most successful traders will tell you that they are most profitable when they make long-term trades. In fact, many of the most successful traders will not close their positions until their profit targets are met or the fundamentals surrounding the trade have changed.

    Be that as it may, there are still countless others who are quite successful at making quick profits from day trading.

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    How Day Trading Differs from Investing, Swing and Position Trading

    Dow Jones Screen Capture Day trading is not investing. Investors put money into a business and, in essence, have a vested interest in that business. On the other hand, day traders simply try to make money from the intra-day movement of a security. Therefore, a day trader may enter a trade in the morning and close the trade that same business day.

    The typical day trader will enter several trades each day, taking small profits from each. To maximize the gains from relatively small daily price moves, day traders will use leveraging which has the power to inflate profits from even small moves in the market. In a similar way, leveraging can amplify losses as well. A leveraged account allows the trader to trade multiples of what his/her account would normally allow. For example a 10:1 leverage would allow someone with just $1,000 to enter a trade of up to $10,000.

    In essence, day trading is very short term trading; a day trader may enter a trade that remains open from a few minutes to a few hours. This is in contrast to investing which makes a commitment for years. Position trading on the other hand involves holding trades for months and swing trading involves holding trades for days.

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    Advantages of Day Trading

    Profit from small market moves – It can take days or even weeks for a trade to make a significant move that will give a reasonable profit. Day traders can profit from small moves while long term traders are left waiting for the big move.

    Eliminate the risk associated with leaving a trade open overnight – Because trades aren’t usually left overnight, day trading can eliminates the risk that a trade can go negative in the event that something unforeseen happens.

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    Disadvantages of Day Trading

    Encourages over-trading – Getting in the habit of entering and closing a trade every few minutes or hours only guarantees that the broker will make a profit, since they make money whenever trades are opened and closed. Sometimes it is better to wait on a good trading opportunity instead of trying to trade every price tick.

    No dividend or interest – Not holding a stock for the near to long-term in many cases ensures that you won’t qualify for a dividend payment if one is made. Depending on the broker you use, not holding a forex trade overnight will limit any interest rate payment gains you may receive from holding a trade for days.

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    Common Trading Style

    Day traders heavily rely on technical analysis. As a result of the short-term nature of day trading, those who adapt to this trading style are often technical traders. In essence, they enter and close trades based on technical indicators (i.e., EMA lines, RSI histograms, Fibonacci extensions and retracements, etc.) rather that analyzing the underlying economic realities that may affect the instrument.

    Many traders have proven that technical analysis can be an effective day trading strategy, but it is more effective when fundamentals are also considered. While day traders don’t need to follow economic releases and earnings reports, having a handle on these issues will undoubtedly give the trader an advantage.

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    What Does it Take to Successfully Day Trade?

    In theory anyone can become a successful day trader, but there are certain skills and personality traits that one must possess to be successful. Some of these include:

    Discipline - First of all, a day trader must have discipline. You may have crafted the perfect trading plan and back-tested it to ensure that it works with a high win loss ratio, but that plan is of no use if it is not followed. A good trader will follow his trading plan even when his emotions scream out to do otherwise.

    Patience – The market will not always present the right trading conditions when the trader is ready. A good trader must be patient and wait for the right conditions; he must also learn to walk away from the trading station when good conditions don’t exist.

    Analytical – Successful trading requires that one has the ability to read the charts, technical indicators and fundamental information (earning reports, economic data etc) in order to determine whether to take a trade and what direction to trade in (long/up or short/down).

    Have at least a basic understanding of economics – Even though day traders are predominantly technical traders, there is no doubt that fundamentals also move the market. Therefore, it is to the trader’s advantage to have a good understanding of how to analyze earnings report and interpret economic data.

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    Getting Started

    Depending on the broker you choose, it is possible to start trading with as little as $1. Even so, some brokers won’t allow you to open an account unless you have a few thousand dollars to fund the new trading account. Before getting started, it is always a good idea to study and understand the basic concepts that are relevant to trading. For example, you must understand the difference between fundamental and technical and how to trade these strategies effectively.

    You must become familiar with trading patterns. Some of the trading patterns you should know include: dojis, double tops, double bottoms and engulfing patterns. These patterns can’t be traded in isolation so you must also understand how indicators are applied and used. Familiarize yourself with the RSI, EMA lines, Fibonacci retracement and extensions levels, etc.

    Before you put a dollar into trading you should use a demo account to develop, and extensively test, any strategy you will be using. There is no effective way of knowing that you are ready to start trading unless you practice and proof your methods. You will need to practice on a demo account for some time before you are ready to start trading with real money. Please be aware that there is something in our psyche that makes us act differently when real money is being risked. Traders often find themselves trading a little differently once they graduate from their demo account to start live trading.

    Finally, find a broker that offers trading in the instruments you are interested in and ensure that the broker’s trading platform will allow you to trade from your mobile, has trailing stops, price alerts and similar features if you might need them.

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    1. Lien, Kathy, “Day trading the currency market: technical and fundamental strategies to profit from market swings Volume 260 of Wiley trading series Day Trading & Swing Trading the Currency Market,” John Wiley and Sons, 2006: P 40
    2. Ann C. Logue, MBA, "Day Trading for Dummies,"John Wiley and Sons, 2011: P12

    Image credits:

    "What's Your Trading Strategy?"

    "How does day trading work," YoTuT