Investing in stocks can move people closer to their long-term financial goals and generate extra cash flow. While some investors embrace the buy-and-hold approach, others aim to capitalize on price fluctuations in the market.
The latter group, also known as day traders, are much more active in the stock market. They enter and exit positions much quicker than long-term investors. Day traders tend to focus on technical analysis, which is based on chart patterns and trends. There's still some focus on financials, but that's a stronger emphasis for long-term investors.
Long-term investors hold onto their favorite companies for many years and occasionally monitor their portfolios. However, day traders play a more active role and stay on top of the market every day.
How do day traders profit, and what are their guiding principles? If you are interested in day trading, these guidelines will help:
- Introduction to day trading.
- Characteristics of a successful day trader.
- Managing risk in day trading.
- Tips for success in day trading.
- Importance of staying informed in day trading.
Introduction to Day Trading
Day traders aim to beat the market by correctly timing their entries and exits across many highly liquid assets, such as stocks and cryptocurrencies. A longer-term investor may look at a company's financials and future opportunities, but that's not the main focus for day traders.
Enzo Villani, CEO of Alpha Transform Holdings and chief investment officer at Alpha Sigma Capital, explains what gets a day trader's attention: "Day traders use different patterns based on technical analysis to make profitable trades. This involves studying charts and predicting future price movements using historical market data."
Concept of Buying and Selling in Day Trading
Day traders look for patterns like breakouts and pullbacks to assess their positions. Breakouts involve a stock's price breaking out of a certain range, while pullbacks involve a stock failing to get past its resistance line.
Some day traders wait for several minutes before buying or selling a stock. Timing is critical for them, down to the last penny. Some day traders set limit orders that initiate trades at desired strike prices so they do not have to wait several minutes or hours for the stock to reach that price point.
Characteristics of a Successful Day Trader
Becoming successful in any industry requires a plan, and day trading is no different. While day trading is filled with short-term investments, there is a lot of planning that goes into an effective strategy.
Discipline and Patience
Ron Wheeler, senior options strategist and director of options education at VectorVest Inc., encourages day traders to keep a long-term approach: "Traders need to become masters at the system they are using. Too often in my career, I see people throwing out good systems because of poor short-term results. In my own career, the patterns and systems I used to make money for years were the very same ones that caused me most of my losses in my early career."
Strong Analytical Skills
Day traders should commit to learning technical indicators and various patterns. Stochastic trends, resistance lines, oscillators and moving averages are some of the technical indicators available to day traders.
You don't have to know every indicator when you get started. However, you can learn with trading simulators that don't involve real money. Practicing with simulators can help you feel more confident with your day-trading strategy when you test it out with real money.
Able to Keep a Cool Head When Taking Risks
Simulations and using small sums of money when getting started can help day traders navigate the emotional intensity of the industry. Villani explains how important it is to keep a cool head when day trading.
"Day trading entails high stress and emotional intensity, emphasizing the importance of maintaining composure and concentration under pressure. This necessitates effectively managing expectations, maintaining detachment from individual trades and displaying discipline in adhering to the established trading plan."
Consistent and Quick Decision-Making Ability
Day traders stick with their strategies and learn from their mistakes without letting individual trades crush their spirits.
Managing Risk in Day Trading
Some day traders make substantial gains within a short amount of time and post their gains online. It's the moonshot gains where traders quickly make a tenfold return on their money with a single trade that attract many speculators.
Day trading may look like a get-rich-quick scheme to people who are getting started, but most day traders end up underperforming the stock market. The line between day trading and gambling can get blurry if traders engage in high-risk positions without thinking about the potential downside.
Tools for Managing Risk in Day Trading
Traders can use stop-loss orders to put a cap on how much they can lose from each position. You can decide on the stop-loss amount. If you buy a stock at $100 per share and set a stop-loss order at $95 per share, your broker will automatically sell the stock the moment its market price falls to $95 per share.
Day traders investing in more volatile assets may want to consider a 10% stop-loss order. Options regularly see 5% and 10% price swings in a single day, which creates the risk of missing out on a potential recovery. For more volatile securities, stop-loss orders can sometimes be counterproductive, as there's a high probability the position will be down by a given amount at some point in time.
Each day trader should assess their risk tolerance before setting stop-loss orders.
Developing a Risk Management Plan
Having guardrails in place can help traders manage risk, but Villani also recommends portfolio diversification.
"Day traders should avoid concentrating solely on one market or asset and instead diversify their trades across different markets and instruments. This approach helps mitigate the impact of unforeseen events or market fluctuations," Villani says.
If you trade, you shouldn't only trade tech stocks or exclusively focus on cryptocurrencies. Just like long-term investors, day traders should diversify their positions across many sectors. It's easier to recover from an unprofitable trade if you spread your money across dozens of positions than if you only spread your capital across three assets.
Tips for Success in Day Trading
A smaller loss is easier to recover from, and you don't need to be right with every trade or even 80% of them. Wheeler predicts he is accurate with 55% of his trades, at best, but he says day traders can beat the market if they are right half of the time.
"The key element of my trading was the overall risk-reward of my trades," Wheeler says. "For every $1 of risk, my return was expected to be $1.50. This allows me to be 50% right and still make money overall. Before I took a trade, I needed to set a pre-established profit target based on previous highs or lows in the patterns I was looking for."
He adds, "As a trade went in my direction, I would exit small amounts of my trade along the way to lock in profits and adjust my stops to prevent a trade reversing and turning a winner into a loss."
Knowing when to walk away from good and bad trades can reduce the percentage of successful trades a day needed to outperform the market. A single profitable trade can help compensate for a few unprofitable trades.
Importance of Staying Informed in Day Trading
Savvy day traders combine their knowledge of technical indicators with an understanding of the context surrounding assets.
"Day traders must consistently monitor and adapt their risk management strategies to align with changing market conditions. As the market evolves, so should the risk management approach," Villani explains.
Monitoring market conditions and staying on top of the latest economic news can increase a day trader's success rate. Day traders can become successful in the field by continuing to practice and learn about additional technical indicators.
