Generally the discussion here is focused on long-term investing for retirement, buying a home or saving for college but I receive questions occasionally in regards to trading for short-term gains. One of the most popular topics of interest seems to be day trading and how someone can get started trading from their own computer. While it is possible to trade for a living I do caution you that it can be risky and is not meant to be a substitute for long-term saving and investing. That being said, you may find some information about day trading helpful if it is something you are considering.
Day trading generally refers to buying and selling a security during a single trading day. This term became popular in the late nineties as technology stocks were experiencing rapid growth. The potential for significant gains in a short amount of time combined with the increasing ability to utilize trading platforms via the Internet allowed this practice to become available to regular investors.
Even though the general conception is that day trading is thought of trading shares of stock, you can practice day trading with virtually any financial instrument. Day traders participate in buying and selling stocks, options, bonds, futures and even currency. Each market provides different opportunities for the trader and some even allow 24-hour trading. A common misconception is that all day traders are very active traders. While some day traders can be quite active and place hundreds of trades in a single day, many others place only a few trades in any given day.
Trading vs. Investing
Unlike typical long-term investors who hold a single investment for days, weeks, months or even years, day traders typically follow one golden rule: never hold an investment overnight. Day traders rely on watching price movements in real-time, so holding an investment overnight subjects the trader to substantial risk in the event some sort of news comes out before the market opens the next morning. This could cause an unexpected gap in price from the previous market close and eliminate any gains the trader incurred the day before or even result in a loss.
Most investors spend time researching investments trying to find a strong company that is poised to increase in value over time. Day traders almost never consider the financial state of the companies they are trading and in fact, may not know anything about a company other than the stock ticker itself. Traders rely entirely on the price movements of their trade over the course of seconds, minutes or hours, whether increasing or decreasing. This short-term focus requires the use of technical analysis instead of the more familiar fundamental analysis, which means that charts and data points, not balance sheets and profit margins, make up the information required to place a trade.
Because day trading is high-risk and utilizes short-term trading in volatile markets, the SEC and NASD have adopted some requirements that recognized day traders must follow. One of the most significant rules define ‘pattern day traders.’ A pattern day trader is anyone who places four or more round-trip trades during any consecutive five business day period. A round-trip trade is one in which a single security or option contract is purchased and subsequently sold during a single trading session.
Traders who meet these requirements must adhere to the restriction of maintaining an equity balance of at least $25,000 in a margin account to be able to participate in day trading activities. Although you do not need $25,000 in your brokerage account in order to place a day trade, repeated day trades within the five-day timeframe set by the SEC will flag you as a pattern day trader.
Because day trading must be conducted in a margin account, if your trading activity is determined to qualify as pattern day trading and your account does not meet the $25,000 equity minimum a margin call will be made that asks the account owner to bring the equity level to the minimum. When this request is not satisfied the account will be restricted and buying power frozen until you meet the minimum equity level or 90 days pass.
Clearly there is significant risk involved when dealing with very short-term trading. Unlike a buy and hold strategy that covers years and can be relatively predictable the short-term markets are extremely volatile. There is nothing wrong with day trading as long as the money used is money you could afford to lose. Before even considering day trading you should ensure the rest of your financial house is in order. Do people become rich by day trading? Yes. Do people lose tens of thousands of dollars in a matter of minutes day trading? Yes. Done properly it can be a viable source of income, but be wary of any commercials, books or people telling you how easy it is to become rich doing it.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.