Investing 101: How Day Trading Works

(photo: iStockPhoto)

Most investors – particularly those just starting out or with limited funds to invest – are best served by a portfolio of mutual funds or exchange-traded funds that fits their risk tolerance and investment horizon. Then hold on to that portfolio for the long term, with once- or twice-a-year tweaks to make sure they remain in the proper asset allocation.

But there are many investors who, after years of researching and managing their investments, have built up a solid knowledge base of stock or fund picking and are willing to take it to the next level. (Others can simply afford to set aside a certain amount of cash to “play with” on the stock market.) Those people move money in and out of positions on a daily basis — and take their profits from day to day rather than waiting for months or years.

They are not simply investors – they are traders.

Most traders are continually seeking an edge in the market and, for many, short-term price movement is the key. Opportunities are found not in holding positions open for weeks or even for days, but by getting in and out in a single day.

But while great profits are possible, so are great losses. Day trading — buying and selling all within a single trading day — is high-risk and it is very difficult to consistently make a profit from this activity. In fact, timing entry and exit is far more complex than many novice traders realize. (You’ve probably heard it a million times already: most people who try to time the market aren’t successful.)

The goal of opening and closing positions within a single day is based on the belief that changes from one day to the next can be severe and impossible to manage. A day’s opening price is not always the same as the previous day’s close, so day traders want to finalize their trades to avoid the risk of potential price movements after hours. (These price movements are called negative price gaps.)

So how do they do it? To begin with, day traders use very short-term price charts. For example, instead of the popular and widely used daily chart, day traders might use a 20-minute or even a 5-minute or 1-minute chart to pick the best points to enter and exit positions. Deciding when to enter or exit (in other words, buy a certain amount of shares and sell them all) can be based on a broad range of momentum indicators, moving averages, or chart patterns.

Some traders use strictly their own money, while others borrow funds through margin accounts.

An interesting twist here is that interest on margin borrowing is charged only when positions are left open overnight. Because the rules for margin limits and interest are based on balances at the end of the day, a day trader can make trades that always close before the end of trading, essentially avoiding having to pay interest. This loophole is yet another incentive for a trader to enter and exit a position within the day — and has led the Securities and Exchange Commission (SEC) to establish a rule for “pattern day traders.”

A pattern day trader is anyone who executes four or more day trades within five consecutive trading days.

The rule: a person falling into this classification must keep no less than $25,000 of cash or equities in their margin account at all times. If this balance falls below the required minimum, no further positions can be opened in the margin account. Once the pattern day trading restriction is set, it remains for at least three months before you can have that restriction removed.

And if these margin limits and restrictions aren’t enough to make your head spin, consider the complexity of timing buy and sell decisions on a daily basis. It might look easy from the outside, but short-term trading is a high-risk business. If anyone tells you to try it because it’s easy money, take that advice with a grain of salt.

Remember: don’t trade with money that you cannot afford to lose. It takes only one big loss to wipe out several smaller profits.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

Investing 101: How Day Trading Works was provided by Minyanville.com.