The Basics of Day Trading
by Carmelo J. Montalbano
The Basics of Day Trading
Day trading is a difficult business that requires capital, thorough knowledge of the stock market, great discipline and an ability to study price screens throughout the day. Day trading requires substantial start-up expense, high overhead, skillful money management procedures, and a personality that can handle several strings of losses.
Potential day traders should have considerable skills in mathematics and a work history that demonstrates the ability to be a self-motivated worker.
Day Traders Must Have a Tested Strategy Before Trading
Day trading requires a portfolio strategy that has been tested on a wide range of stocks, commodities and bonds. Actually, the trader should develop several strategies that work under bullish, bearish and neutral scenarios. Good strategies can be mapped on paper before the trade and followed as a road map. Successful trading begins with a set-up (recognition that a stock is poised to trade in a trend either long or short). Strategy must include both an entry strategy that begins a trade with little volatility and an exit strategy for closing the trade. The strategy must include protective stops to minimize losses upon entry and an exit strategy that retains the bulk of the profit made.
Money Management Is a Paramount Concern for Day Traders
Money management requires an understanding that profits do not come in any regular order. Profits and losses tend to come in trends and the day trader must be able to able to absorb a series of losses both economically and psychologically. Day traders try to follow trends and capture as much as possible from a market move. Money management requires that no one loss or no series of losses should be large enough to force you to stop trading. Day traders use formulas that employ variable amounts of risk for each trade with no one trade absorbing more than two or three percent of the total amount of available capital. Thus a string of five losses of 2 percent can be made up in one successful trade. This is unlikely to happen if the risk per trade is 10 percent. Strings of losses affect traders emotionally, bringing into question their own abilities.
Day Trading Requires Disciplined Use of Stops
Discipline is the most important trait of a good day trader. Discipline insists that every trade have a beginning and end determined by a strategy. This loss is enforced by protective stops. Protective stops are placed throughout the period of the trade. Typically a protective stop limits losses to no more than an 8 percent loss on any trade. Discipline must be used to obey loss limits and to avoid letting small losses become large losses. When a trade is profitable there should always be protective stops as well, such as exiting a trade once a stock has retreated 15 percent from its high. Another popular stop is to sell half of a profitable position if it gains 20 percent. Day trading is about preserving capital first and gains second.
Practical Considerations of Day Trading
Do not start day trading without an outside source of income. Profits are erratic and are sometimes marked by long stretches of mediocre profits and losses. Start-up and fixed expenses are very high. You will need programs like Metastock to develop trading strategies. This requires the cost of the program plus the online feed. Traders require high-speed Internet connections and backup systems if power fails, multiple brokers in case phone lines are jammed, telephone lines, and expensive real-time quote systems that show all size, bid and offered prices by all traders instantaneously. Detailed, real-time quote systems are provided through your broker for a fee. It is necessary for traders to have these systems in every exchange they trade in order to measure whether the underlying trend of a stock is gaining or losing strength. Almost all traders use online brokers for the speed and accuracy and the much lower commission prices. Buy and sell commissions, also called round-trip costs, are substantial, especially when considering that at least half of all trades fail. You must make as much money as possible on profitable trades to make up for the cost of failed trades.
Don't Underestimate the Difficulties of Day Trading
Most traders fail at day trading. Traders are competing directly against customer orders, brokers servicing customer orders, and other day traders who can ride the coattails of real investors making real buy and sell decisions with very large volume. In addition to the costs above, traders pay slippage (the difference between the buy and sell price for every trade they make). Traders may lose faith in their system after a consecutive string of losses or after several days of weeks of low or no profits. Day trading requires steely discipline, especially in bad times, and it helps to have other investment experience measured in years, before attempting day trading as a career.