What is Day-Trading

What is Day-Trading

Day trading is speculation in securities, specifically buying and selling financial instruments within the same trading day, such that all positions are usually closed before the market close for the trading day. Traders who participate in day trading are called active traders or day traders. Traders who trade in this capacity with the motive
of profit assume the capital markets’ role of speculator.

Some of the more commonly day-traded financial instruments are stocks, options, currencies, and a host of futures contracts such as equity index futures, interest rate futures, and commodity futures.

Day trading was once an activity that was exclusive to financial firms and professional speculators. Many day traders are bank or investment firm employees working as specialists in equity investment and fund management. However, with the advent of electronic trading and margin trading, day trading has become increasingly popular among at-home traders.

Characteristics
Some day traders focus only on price momentum, others on technical patterns. Some traders choose to focus on a limited number of strategies they feel can be profitable.

Some day traders use an intra-day technique known as scalping that usually has the trader holding a position for a few minutes or even seconds.

Most day traders exit positions before the market closes to avoid unmanageable risks— negative price gaps (differences between the previous day’s close and the next day’s open bull price) at the open—overnight price movements against the position held. Other traders believe they should let the profits run, so it is acceptable to stay with a position after the market closes.[1]

Day traders sometimes borrow money to trade. This is called margin trading. Since margin interests are typically only charged on overnight balances, the trader pays no fees for the margin benefit, though still running the risk of a margin call. The margin interest rate is usually based on the broker’s call.

Profit and risks
Because of the nature of financial leverage and the rapid returns that are possible, day trading results can range from extremely profitable to extremely unprofitable, and high-risk profile traders can generate either huge percentage returns or huge percentage losses. Because of the high profits (and losses) that day trading makes possible, these traders are sometimes portrayed as “bandits” or “gamblers” by other investors. Some[who?] individuals, however, make a consistent living from day trading.

Nevertheless day trading can be risky, especially if any of the following is present while trading:

trading a loser’s game/system rather than a game that’s at least winnable,  trading with poor discipline (ignoring your own day trading strategy, tactics, rules), inadequate risk capital with the accompanying excess stress of having to “survive”, incompetent money management (i.e. executing trades poorly).[2][3]

The common use of buying on margin (using borrowed funds) amplifies gains and losses, such that substantial losses or gains can occur in a very short period of time. In addition, brokers usually allow bigger margins for day traders. Where overnight margins required to hold a stock position are normally 50% of the stock’s value, many brokers allow pattern day trader accounts to use levels as low as 25% for intraday purchases. This means a day trader with the legal minimum $25,000 in his or her account can buy $100,000 (4x leverage) worth of stock during the day, as long as half of those positions are exited before the market close. Because of the high risk of margin use, and of other day trading practices, a day trader will often have to exit a losing position very quickly, in order to prevent a greater, unacceptable loss, or even a disastrous loss, much larger than his or her original investment, or even larger than his or her total assets.

History
Originally, the most important U.S. stocks were traded on the New York Stock Exchange. A trader would contact a stockbroker, who would relay the order to a specialist on the floor of the NYSE. These specialists would each make markets in only a handful of stocks. The specialist would match the purchaser with another broker’s seller; write up physical tickets that, once processed, would effectively transfer the stock; and relay the information back to both brokers. Brokerage commissions were fixed at 1% of the amount of the trade, i.e. to purchase $10,000 worth of stock cost the buyer $100 in commissions. (Meaning that to profit trades had to make over 1.010101…% to make any real gain.)

One of the first steps to make day trading of shares potentially profitable was the change in the commission scheme. In 1975, the United States Securities and Exchange Commission (SEC) made fixed commission rates illegal, giving rise to discount brokers offering much reduced commission rates.

Financial settlement Financial settlement periods used to be much longer: Before the early 1990s at the London Stock Exchange, for example, stock could be paid for up to 10 working days after it was bought, allowing traders to buy (or sell) shares at the beginning of a settlement period only to sell (or buy) them before the end of the period hoping for a rise in price. This activity was identical to modern day trading, but for the longer duration of the settlement period. But today, to reduce market risk, the settlement period is typically three working days. Reducing the settlement period reduces the likelihood of default, but was impossible before the advent of electronic ownership transfer.

Electronic communication networks

The systems by which stocks are traded have also evolved, the second half of the twentieth century having seen the advent of electronic communication networks (ECNs). These are essentially large proprietary computer networks on which brokers could list a certain amount of securities to sell at a certain price (the asking price or “ask”) or offer to buy a certain amount of securities at a certain price (the “bid”).

ECNs and exchanges are usually known to traders by a three- or four-letter designators, which identify the ECN or exchange on Level II stock screens. The first of these was Instinet (or “inet”), which was founded in 1969 as a way for major institutions to bypass the increasingly cumbersome and expensive NYSE, also allowing them to trade during hours when the exchanges were closed. Early ECNs such as Instinet were very unfriendly to small investors, because they tended to give large institutions better prices than were available to the public. This resulted in a fragmented and sometimes illiquid market.

The next important step in facilitating day trading was the founding in 1971 of NASDAQ—a virtual stock exchange on which orders were transmitted electronically. Moving from paper share certificates and written share registers to “dematerialized” shares, computerized trading and registration required not only extensive changes to legislation but also the development of the necessary technology: online and real time systems rather than batch; electronic communications rather than the postal service, telex or the physical shipment of computer tapes, and the development of secure cryptographic algorithms.

These developments heralded the appearance of “market makers”: the NASDAQ equivalent of a NYSE specialist. A market maker has an inventory of stocks to buy and sell, and simultaneously offers to buy and sell the same stock. Obviously, it will offer to sell stock at a higher price than the price at which it offers to buy. This difference is known as the “spread”. The market maker is indifferent as to whether the stock goes up or
down, it simply tries to constantly buy for less than it sells. A persistent trend in one direction will result in a loss for the market maker, but the strategy is overall positive (otherwise they would exit the business). Today there are about 500 firms who participate as market-makers on ECNs, each generally making a market in four to forty different stocks. Without any legal obligations, market-makers were free to offer smaller spreads on ECNs than on the NASDAQ. A small investor might have to pay a $0.25 spread (e.g. he might have to pay $10.50 to buy a share of stock but could only get $10.25 for selling it), while an institution would only pay a $0.05 spread (buying at $10.40 and
selling at $10.35).

Technology bubble (1997–2000)

Following the 1987 stock market crash, the SEC adopted “Order Handling Rules” which
required market-makers to publish their best bid and ask on the NASDAQ. Another reform
made was the “Small Order Execution System”, or “SOES”, which required market makers to
buy or sell, immediately, small orders (up to 1000 shares) at the market-makers listed
bid or ask. The design of the system gave rise to arbitrage by a small group of traders
known as the “SOES bandits”, who made sizable profits buying and selling small orders to
market makers by anticipating price moves before they were reflected in the published
inside bid/ask prices. The SOES system ultimately led to trading facilitated by software
instead of market makers via electronic communications networks (“ECNs”).

In the late 1990s, existing ECNs began to offer their services to small investors. New
brokerage firms which specialized in serving online traders who wanted to trade on the
ECNs emerged. New ECNs also arose, most importantly Archipelago (“arca”) and Island
(“isld”). Archipelago eventually became a stock exchange and in 2005 was purchased by the
NYSE. (At this time, the NYSE has proposed merging Archipelago with itself, although some
resistance has arisen from NYSE members.) Commissions plummeted. To give an extreme
example (trading 1000 shares of Google), an online trader in 2005 might have bought
$300,000 of stock at a commission of about $10, compared to the $3,000 commission the
trader would have paid in 1974. Moreover, the trader was able in 2005 to buy the stock
almost instantly and got it at a cheaper price.

ECNs are in constant flux. New ones are formed, while existing ones are bought or merged.
As of the end of 2006, the most important ECNs to the individual trader were:

Instinet (which bought Island in 2002), Archipelago (although technically it is now an exchange rather than an ECN), the Brass Utility (“brut”), and the SuperDot electronic system now used by the NYSE. The evolution of average NASDAQ share prices between 1994 and 2004 This combination of factors has made day trading in stocks and stock derivatives (such as ETFs) possible. The low commission rates allow an individual or small firm to make a large number of trades during a single day. The liquidity and small spreads provided by ECNs allow an individual to make near-instantaneous trades and to get favorable pricing. High-volume issues such as Intel or Microsoft generally have a spread of only $0.01, so the price only needs to move a few pennies for the trader to cover his commission costs and show a profit.

The ability for individuals to day trade coincided with the extreme bull market in technological issues from 1997 to early 2000, known as the Dot-com bubble. From 1997 to 2000, the NASDAQ rose from 1200 to 5000. Many naive investors with little market experience made huge profits buying these stocks in the morning and selling them in the afternoon, at 400% margin rates.

In March, 2000, this bubble burst, and a large number of less-experienced day traders began to lose money as fast, or faster, than they had made during the buying frenzy. The NASDAQ crashed from 5000 back to 1200; many of the less-experienced traders went broke, although obviously it was possible to have made a fortune during that time by shorting or playing on volatility.

In parallel to stock trading, starting at the end of the 1990s, a number of new Market Maker firms provide foreign exchange and derivative day trading through new electronic trading platforms. These allowed day traders to have instant access to decentralized markets such as forex and global markets through derivatives such as contracts for difference. Most of these firms were based in the UK and later in less restrictive jurisdiction, this was in part due to the regulations in the US prohibiting this type of over-the-counter trading. These firms typically provide trading on margin allowing day traders to take large position with relatively small capital, but with the associated increase in risk. Retail forex trading became a popular way to day trade due its liquidity and the 24 hour nature of the market.

Techniques

The following are several basic strategies by which day traders attempt to make profits.
Besides these, some day traders also use contrarian (reverse) strategies (more commonly
seen in algorithmic trading) to trade specifically against irrational behavior from day
traders using these approaches. It is important for a trader to remain flexible and
adjust their techniques to match changing market conditions.[4]

Some of these approaches require shorting stocks instead of buying them: the trader
borrows stock from his broker and sells the borrowed stock, hoping that the price will
fall and he will be able to purchase the shares at a lower price. There are several
technical problems with short sales—the broker may not have shares to lend in a specific
issue, some short sales can only be made if the stock price or bid has just risen (known
as an “uptick”), and the broker can call for the return of its shares at any time. Some
of these restrictions (in particular the uptick rule) don’t apply to trades of stocks
that are actually shares of an exchange-traded fund (ETF).

The Securities and Exchange Commission removed the uptick requirement for short sales on
July 6, 2007.[5]

Trend following
Main article: Trend following
Trend following, a strategy used in all trading time-frames, assumes that financial
instruments which have been rising steadily will continue to rise, and vice versa with
falling. The trend follower buys an instrument which has been rising, or short sells a
falling one, in the expectation that the trend will continue.

Contrarian investing
Main article: Contrarian investing
Contrarian investing is a market timing strategy used in all trading time-frames. It
assumes that financial instruments which have been rising steadily will reverse and start
to fall, and vice versa. The contrarian trader buys an instrument which has been falling,
or short-sells a rising one, in the expectation that the trend will change.

Range trading
Main article: Swing trading
Range trading, or range-bound trading, is a trading style in which stocks are watched
that have either been rising off a support price or falling off a resistance price. That
is, every time the stock hits a high, it falls back to the low, and vice versa. Such a
stock is said to be “trading in a range”, which is the opposite of trending.[6] The range
trader therefore buys the stock at or near the low price, and sells (and possibly short
sells) at the high. A related approach to range trading is looking for moves outside of
an established range, called a breakout (price moves up) or a breakdown (price moves
down), and assume that once the range has been broken prices will continue in that
direction for some time.

Scalping
Main article: scalping (trading)
Scalping was originally referred to as spread trading. Scalping is a trading style where
small price gaps created by the bid-ask spread are exploited by the speculator. It
normally involves establishing and liquidating a position quickly, usually within minutes
or even seconds.

Scalping highly liquid instruments for off-the-floor day traders involves taking quick
profits while minimizing risk (loss exposure). It applies technical analysis concepts
such as over/under-bought, support and resistance zones as well as trendline, trading
channel to enter the market at key points and take quick profits from small moves. The
basic idea of scalping is to exploit the inefficiency of the market when volatility
increases and the trading range expands.

Rebate trading
Main article: Rebate trading (trading)
Rebate trading is an equity trading style that uses ECN rebates as a primary source of
profit and revenue. Most ECNs charge commissions to customers who want to have their
orders filled immediately at the best prices available, but the ECNs pay commissions to
buyers or sellers who “add liquidity” by placing limit orders that create “market-making”
in a security. Rebate traders seek to make money from these rebates and will usually
maximize their returns by trading low priced, high volume stocks. This enables them to
trade more shares and contribute more liquidity with a set amount of capital, while
limiting the risk that they will not be able to exit a position in the stock. Rebate
trading was pioneered at Datek Online and Domestic Securities. Omar Amanat founded
Tradescape and the rebate trading group at Tradescape helped to contribute to a $280
million buyout from online trading giant E*Trade.

News playing
News playing is primarily the realm of the day trader. The basic strategy is to buy a
stock which has just announced good news, or short sell on bad news. Such events provide
enormous volatility in a stock and therefore the greatest chance for quick profits (or
losses). Determining whether news is “good” or “bad” must be determined by the price
action of the stock, because the market reaction may not match the tone of the news
itself. This is because rumors or estimates of the event (like those issued by market and
industry analysts) will already have been circulated before the official release, causing
prices to move in ancitipation. The price movement caused by the official news will
therefore be determined by how good the news is relative to the market’s expectations,
not how good it is in absolute terms.

Price action
Keeping things simple can also be an effective methodology when it comes to trading.
There are groups of traders known as price action traders who are a form of technical
traders that rely on technical analysis but do not rely on conventional indicators to
point them in the direction of a trade or not. These traders rely on a combination of
price movement, chart patterns, volume, and other raw market data to gauge whether or not
they should take a trade. This is seen as a “simplistic” and “minimalist” approach to
trading but is not by any means easier than any other trading methodology. It requires a
sound background in understanding how markets work and the core principles within a
market, but the good thing about this type of methodology is it will work in virtually
any market that exists (stocks, foreign exchange, futures, gold, oil, etc.).

Candlestick charts
Candlestick charts are used by traders using technical analysis to determine chart
patterns. Once a pattern is recognized in the chart, traders use the information to take
a position. Some traders consider this method to be a part of price action trading.

Artificial intelligence
An estimated one third of stock trades in 2005 in United States were generated by
automatic algorithms, or high-frequency trading. The increased use of algorithms and
quantitative techniques has led to more competition and smaller profits.[7]

Cost
Trading equipment
Some day trading strategies (including scalping and arbitrage) require relatively
sophisticated trading systems and software. This software can cost $45,000 or more. Since
laymen have now entered the day trading space, strategies can now be found for as little
as $5,000. Many day traders use multiple monitors or even multiple computers to execute
their orders. Some use real time filtering software which is programmed to send stock
symbols to a screen which meet specific criteria during the day, such as displaying
stocks that are turning from positive to negative. Some traders use community based tools
including forums and chat rooms.

Brokerage
Day traders do not use discount brokers because they are slower to execute trades, trade
against order flow, and charge higher commissions than direct-access brokers, who allow
the trader to send their orders directly to the ECNs. Direct access trading offers
substantial improvements in transaction speed and will usually result in better trade
execution prices (reducing the costs of trading). Outside the US, day traders will often
use CFD or financial spread betting brokers for the same reasons.

Commission
Commissions for direct-access brokers are calculated based on volume. The more shares
traded, the cheaper the commission. The average commission per trade is roughly $5 per
round trip (getting in and out of a position). While a retail broker might charge $7 or
more per trade regardless of the trade size, a typical direct-access broker may charge
anywhere from $0.01 to $0.0002 per share traded (from $10 down to $.20 per 1000 shares),
or $0.25 per futures contract. A scalper can cover such costs with even a minimal gain.

As for the calculation method, some use pro-rata to calculate commissions and charges,
where each tier of volumes charges different commissions. Other brokers use a flat rate,
where all commissions and charges are based on which volume threshold one reaches.

Spread
Main article: Bid and ask
The numerical difference between the bid and ask prices is referred to as the bid-ask
spread. Most worldwide markets operate on a bid-ask-based system.

The ask prices are immediate execution (market) prices for quick buyers (ask takers)
while bid prices are for quick sellers (bid takers). If a trade is executed at quoted
prices, closing the trade immediately without queuing would always cause a loss because
the bid price is always less than the ask price at any point in time.

The bid-ask spread is two sides of the same coin. The spread can be viewed as trading
bonuses or costs according to different parties and different strategies. On one hand,
traders who do NOT wish to queue their order, instead paying the market price, pay the
spreads (costs). On the other hand, traders who wish to queue and wait for execution
receive the spreads (bonuses). Some day trading strategies attempt to capture the spread
as additional, or even the only, profits for successful trades.

Market data
Market data is necessary for day traders, rather than using the delayed (by anything from
10 to 60 minutes, per exchange rules[8]) market data that is available for free. A real-
time data feed requires paying fees to the respective stock exchanges, usually combined
with the broker’s charges; these fees are usually very low compared to the other costs of
trading. The fees may be waived for promotional purposes or for customers meeting a
minimum monthly volume of trades. Even a moderately active day trader can expect to meet
these requirements, making the basic data feed essentially “free”.

In addition to the raw market data, some traders purchase more advanced data feeds that
include historical data and features such as scanning large numbers of stocks in the live
market for unusual activity. Complicated analysis and charting software are other popular
additions. These types of systems can cost from tens to hundreds of dollars per month to
access.

Regulations and restrictions
Day trading is considered a risky trading style, and regulations require brokerage firms
to ask whether the clients understand the risks of day trading and whether they have
prior trading experience before entering the market.

Pattern day trader
Main article: Pattern day trader
In addition, Financial Industry Regulatory Authority and SEC further restrict the entry
by means of “pattern day trader” amendments. Pattern day trader is a term defined by the
SEC to describe any trader who buys and sells a particular security in the same trading
day (day trades), and does this four or more times in any five consecutive business day
period. A pattern day trader is subject to special rules, the main rule being that in
order to engage in pattern day trading in a margin account, the trader must maintain an
equity balance of at least $25,000. It is important to note that this requirement is only
for day traders using a margin account.[9]

Source
wikipedia.org
Category