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How it Works
According to the U.S. Securities and Exchange Commission (SEC) day trading is performed by day traders who buy and sell securities swiftly during the same day hoping to lock in quick profits as the value of financial instruments increases or falls during the trading session. In fact, day trading aims at fully capitalizing on the value of each financial instrument to allow the trader to make quick profits.
The most commonly day traded securities are stocks, options, futures and currencies. Typically, day traders do not hold their positions overnight to avoid high volatility and extreme risk caused by price changes from one trading session to the next. Instead, they trade the securities the same day they purchase them, strictly for profit.
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Given the high volatility of the stock market, day trading can be extremely profitable. Day traders can trade securities and capitalize on the movements of prices as they change every second. This allows them to make significantly high profits within a single trading session.
In majority, day traders possess the experience, skills and the character to accept the significantly high risk of day trading. Being well-educated and able to employ short-term trading strategies that allows them to take advantage of small price movements in highly liquid securities, day traders can effectively deal with trading on margin. In doing so, although they are exposed to the risk of huge financial losses, they can lock in high profits within the same day. Moreover, by keep on trading securities they are responsible for a great percentage of the markets’ liquidity and they essentially keep the financial markets running.
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The risks of day trading are mostly related with the fact that day traders do not risk their own money and are often more elastic with the risk they accept when trading with the values of securities the same day they purchase them.
In majority, money managers and financial professionals argue that the risks of day trading do no justify the returns, except from some special cases. And although there is great profit potential, the success rate of day trading is considerably lower due to high complexity and the risk that day traders have to undertake.
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1. Huge Financial Losses
One of the most common risks is huge financial losses, typically incurred in the first months of trading. Depending on the decisions of day traders during the trading session, the profits may be significant as well as the losses. Especially, if the day trader is not sufficiently experienced to deal with the market volatility and the inherent complexity of day trading, huge financial losses may be suffered.
In fact, day trading wouldn’t be that risky if day traders didn’t risk the money they couldn’t afford to lose. However, day traders trade all available capital in the hope of locking in higher profits during the day, but this money may include retirement funds, mortgage payments or even money to cover living expenses.
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2. High Levels of Stress
Day traders must consistently follow the market in order to capitalize on price fluctuations and correctly spot the market trends. Beyond that, the event of incurring huge financial losses in the blink of an eye can cause high levels of stress, especially when day traders are required to make the right financial decision concerning the buying or selling of securities within demanding time constraints.
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3. Trading On Margin
Day trading relies profoundly on borrowed money, which means day traders trade on margin by putting securities as collaterals to cover the risk of trade. Trading on margin is a high risk, short-term trading strategy that requires day traders to leverage the borrowed money in order to supplement their existing capital and increase their returns. Although it is extremely common amongst day traders, trading on margin exposes day traders to a high risk. If it is successfully implemented, trading on margin can provide high returns. If trading on margin fails, huge financial losses may be incurred, while many day traders end up in debt.
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4. Over Trading
In their aim to make high profits, day traders either trade many open positions with too risky trades or trade large amounts of money on a single trade. In both cases, over trading can result in huge financial losses, either because day traders lack the ability to handle too many trading positions simultaneously or because they are driven by their emotions rather by their knowledge and they make bad position sizing decisions. Over trading is commonly detected by behavioral changes, lack of trading strategy and poor money management that all lead to capital losses.
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5. Lack of Understanding Market Trends
Day traders are focused on riding the momentum of securities and exit their position before the security changes direction. This means they rarely follow market trends and they have little knowledge concerning the future movement of a stock. Instead, they are mostly interested in following the stock value during its upward or downward movements. However, the understanding of market trends is fundamental in day trading because it allows day traders to predict which direction – upward or downward - the stock will move. Moreover, the knowledge of technical analysis and financial and investment analysis is also helpful to reduce the inherent high risk of day trading.
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Although day trading is a high risk, short-term trading strategy, the risks can be avoided if day traders primarily feel comfortable with their knowledge of financial markets. This means knowing how the market behaves, why it behaves in particular ways under particular circumstances, how investor behavior causes the market trends to change abruptly, etc. Market knowledge is extremely important not only in day trading, but also in full trading as well. However, in day trading it is more important due to the higher risk involved in the process.
In addition, day traders should have an understanding of how margin trading works, what are the requirements for effective margin trading, how much time they have available to make a margin call, etc. As already explained, trading on margin is extremely risky and, therefore, it requires a thorough knowledge of its mechanisms.
Finally, avoiding over trading is another suggestion to reduce or eliminate the risks of day trading. Given that over trading requires a particular ability to handle its complexity, day traders should balance their trades to avoid huge losses, especially in the beginning stages.
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Although day trading is highly risky, it can also provide high returns. Maybe this can explain its undeniable prevalence and leading role over the past years in the financial markets. Day traders are essentially keeping the financial markets efficient and liquid by capitalizing on small price movements in highly liquid securities. In spite of the arguments it has raised, day trading is a vehicle to profitability provided it is exercised by experienced traders who can read between the lines and have knowledge of the financial markets.
- Image: worradmu used with permission, http://www.freedigitalphotos.net/images/view_photog.php?photogid=2026
- Day Trading: Your Dollars at Risk http://www.sec.gov/investor/pubs/daytips.htm
- Noble Trading - Over Trading: The Signs and Effects - http://blog.nobletrading.com/2010/05/overtrading-signs-and-effects.html
- Day Trading Risks http://www.jobmonkey.com/daytrading/risks.html
- Image: jscreationzs used with permission, http://www.freedigitalphotos.net/images/view_photog.php?photogid=1152