The Best Strategy for Day Trading

by Carmelo J. Montalbano

Overview

Good day trading strategy will combine risk management, money management, and a buy and sell strategy that can be replicated over and over across a wide variety of stocks, bonds, commodities and other asset classes. Day trading is a business where the number of wins and losses are roughly equal. Profits are made by minimizing losses and maximizing gains with emphasis on minimizing losses.

Trade the Trend Until It Bends
Risk Management

Risk management is hard to achieve when day trading because trading positions are only kept for the day and not enough positions are kept to diversify risk among many stocks, much less other asset classes such as bonds, commodities and precious metals. The best risk management therefore is to use very tight limit losses or stops. Set stops below the 14-day average of the daily range between the high and low stops. Thus a stock at 16 with an average daily range (also known as the atr) of 1.5 would have a stop loss of 14.49. This will give the stock its average volatility but avoid a small loss from becoming a large loss. Typical day traders carry no more than four or five positions at any one time so trading more than one stock in any sector is inadvisable.

Money Management

Money management refers to how much a day trader should invest on any one trade in order to maximize his total profits. The problem should be looked at by asking the question "How many consecutive losses can I absorb before I stop trading?" The answer is up to you, but risking 1 percent of the total portfolio leaves you in the game; 5 percent per trade does not. Yet in a 1,000 trades--four a day--the likelihood of such a string of losses is very probable. What traders count on is making more per winning trade than what is lost in a losing trade. Risk management depends on what investing strategy is being used and the historical ratio of wins to losses.
Strategy and Comfort

There are hundreds of day trading strategies in use. Arbitrage, dividend capture, capital gains, moving averages, stochastic trading, new issue trading and covered call trading all require different skills. Strong math backgrounds are a plus, but in each of the strategies, you need the ability to be rational and exert discipline to take losses if necessary. Traders should study one or two techniques and paper trade for an extended period of time and under bull and bear markets. If the results are successful then consider investing real money.