What is Day Trading?

When you hear the term "day trading", a specific type of financial investment (stocks) springs to mind. Day trading¹ is complex and challenging, and those who don’t know much about this style of trading often equate it to gambling. 

However, this couldn't be further from the truth - day trading is complex, challenging, and skill-based. It often involves serious analysis, both technical and fundamental. The trader needs to closely track the pulse of the market and the stock itself, and has a high barrier to entry.

If you're looking for an expert guide on day trading, including how to get started and which strategies to use, the following guide will point you in the right direction.

What Is Day Trading?

While the entirety of day trading is multilayered and complex, defining it is relatively easy. Day trading is simply a type of investment activity that focuses on both buying and selling assets and securities within the same day. The goal is to make short-term profits from each day's transactions. The profit made from one sale is typically small, so this profit is compounded throughout the day by making multiple transactions until the markets close.

Day trading can lead to meaningful portfolio appreciation when this strategy is employed correctly. At the same time, it can be quite challenging to excel at day trading. It requires engaging in detailed market-trend analysis, selecting securities and strategies carefully, and having a substantially high risk tolerance. Yet with today's increased access to online trading platforms, it's now possible to become a day trader from the comfort of your own home.

Types of Day Trading

There's more than one type of day trading. In fact, here are a handful of the most common types of day trading that you'll encounter regularly.

Momentum Trading

Momentum trading revolves around buying and selling securities based on how strong the current price trends are for those securities. The core concept behind momentum trading is that a price change in a specific asset is likely to continue to change in the same direction in the short term before stabilizing or reversing. It also relies on a time-tested virtuous loop. When a stock reaches a higher price, it attracts more attention from traders and investors, which pushes its price even higher. This continues until a large number of sellers enter the market – for example, due to a change in company fundamentals based on quarterly earnings updates. Once enough sellers take over, the momentum changes direction and will force the stock price lower. The key is to know when to buy or sell that security before the price changes. Strategies for momentum trading often rely on volume, volatility, and time frame. You can read more on momentum trading here.

Range Trading

Range trading depends on the day trader identifying a price range in which the trader buys and sells securities over a short period of time. The concept involves only making trades in the security while its price is within the set target range. This means traders won't buy or sell a stock, for example, if its price drops below or rises above that range. It needs careful technical analysis to establish this range. This trading method seeks to limit risk on losses below the minimum price in the range a day trader establishes.

 Algorithmic Trading

Algorithmic trading uses carefully designed computer programs to place trades on the market. These programs run off an algorithm, which is a predetermined set of rules and instructions, to automate trading activity and unlock speed and efficiency by being able to make transactions faster than any human trader could ever do. Algo trading is completely dependent on the quality of the instructions encoded into the algorithm, as a badly written algorithm will not perform up to expectations. You can read more about algorithmic trading here.

High-Frequency Trading (HFT)

HFT is an advanced form of algorithmic trading that builds on the complexity by several orders of magnitude. Like algorithmic trading, high-frequency trading is chiefly concerned with using carefully-coded algorithms to speed up the trading process. However, HFT takes it one step further by seeking to automate as much of the entirety of day trading as possible to receive an even bigger boost in speed so that a larger volume of trades can be performed in the same amount of time. One of the advantages of using high-frequency or algorithmic trading is that these strategies take human biases out of the decision making process.

Pattern Day Trading (PDT)

Pattern day trading involves using a margin account to make at least four trades over a span of five business days. A pattern day trader is required to hold a minimum of $25,000 in their margin accounts or they will be prohibited from making day trades until this balance is met once more. The presence of a margin account makes this effectively a leveraged trade, and one should be very careful while employing leverage. This stems from the authority of the Financial Industry Regulatory Authority (FINRA), is an independent, nongovernmental organization that both creates and enforces the regulations regarding registered brokers and broker-dealer firms in the US.

How Day Trading Works

Day trading works by capitalizing on market volatility. Traders look for opportunities to profit from short-term market fluctuations by purchasing a security, holding it until the price of that security changes in their favor, and then selling it on the open market to generate a profit. Then, the day trader takes the profit from the sale and, combined with their initial investment capital, uses it to make another short-term purchase shortly thereafter. 

This is, of course, a highly simplified explanation of how day trading works. Yet even simplified as it is, it's still relevant to the core mechanics of day trading. The goal is to build profit over each individual transaction by purchasing securities at a lower price than you sell them for, all while taking into account how these prices can fluctuate, sometimes wildly, during a single day of trading. As a result, day trading takes expert timing, a solid strategy, and a deep understanding of technical analysis to pull off successfully.

How to Get Started Trading

Today, thanks to advances in financial technologies, the barrier to entry for getting started in day trading is lower than it has ever been before. Becoming a day trader still requires some careful preparation, though. Here's what day traders need to get started. 

Margin Account and Brokerage Firm

You will need to open a margin account with a brokerage firm if you want to engage in day trading. Margin accounts are types of brokerage accounts where the account holder deposits cash into the account for the broker-dealer to hold as collateral. In return, the broker provides funds for the investor to use for purchasing securities. 

Pattern Day Trader Rule (PDT)

If you plan on pattern day trading, you will need to have a minimum balance of $25,000 in your margin account at all times as mentioned above. This rule was established to reduce the amount of risk associated with pattern day trading. Violating this rule (making four day trades or more in a single business week) can result in your broker freezing your account until your balance is returned to $25,000.

Risk Tolerance

One of the most important things you'll need as a day trader is to understand how much risk is involved with the practice. Even the most careful and cautious day trader can see their investments disappear in literally seconds due to the highly volatile nature of daily price fluctuations. Therefore, the threat of financial loss is very real. This requires an extremely high tolerance for risk if you want to become a day trader. One should think hard and carefully consider what proportion of their capital they want to employ in day trading strategies.

Sufficient Capital

The $25,000 minimum balance requirement for a margin account is simply the tip of the iceberg when it comes to day trading. You'll need even more capital than that to begin day trading in earnest to ensure that you can offset any temporary losses by keeping that minimum balance. This is perhaps one of the largest barriers to entry remaining to becoming involved in day trading - it's simply impossible to get started without sufficient capital.

Day trading involves making smart, strategic trades that have a high likelihood of turning out in your favor. You'll need to formulate trading strategies and use specialized, full-featured software tools to test and fine-tune those strategies to ensure they're working as intended, such as how trading platform Composer offers backtesting to ensure your automated trading strategies are well thought-out. 

The Risks of Day Trading

Watching constant price fluctuation can be stress inducing

Day trading is not necessarily for the average investor, based solely on the number of risks that day traders are exposed to. Day traders need to be prepared to suffer financial losses, and these losses may be severe. In fact, in many instances, day traders might see several months go by before making a profit. This leads to high levels of stress, both because of the constant threat of losing investment capital but also in having to watch price fluctuations nearly constantly to identify opportunities for growth.

Leverage could be a risky strategy

Because of how difficult it is to begin making a profit in this way, day traders often have a heavy dependency on borrowing investment capital. This provides the leverage necessary to make profit, but when a day trader gets hit with a string of bad trades, they can end up not only losing their own money but winding up in sometimes severe levels of debt as well. Finally, there is a lot of misinformation put out there by "industry experts" that cater to day traders, offering paid classes and seminars or access to "hot tips" for a price, only to not amount to anything whatsoever.

Ignores the compounding that can be achieved through buy-and-hold strategies

Day trading is a much different animal from traditional investing, and in many instances it may be better for someone to stick with a traditional form of investment activity instead of trying day trading. The differences are clear: investing is designed for long-term growth, often using a buy-and-hold strategy to reap rewards over years or even decades. Day trading, instead, is never concerned with holding an asset or a security past the end of the trading day but instead actively buying and selling these securities as quickly as possible to achieve that growth.

Both types of investment activity have inherent risks, of course. A major market crash can erase decades' worth of value that has been accumulating in even the most careful traditional investor's portfolio, after all. Yet the frequency of such events is much, much lower than it is in day trading, where fortunes can be made, lost, and made once more in a matter of minutes or even seconds. This puts day trading at the exact opposite side of the scale as traditional investing.

The Most Popular Day Trading Strategies

It often feels like there are as many different day trading strategies as there are stars in the sky, and that's because there's a near-infinite number of ways to alter and adapt existing strategies by personal preference. Yet even with that being said, there are certain strategies that have become popular due to their ability to perform relatively well. 

These strategies include those listed above, such as range trading and momentum trading. Yet the fastest growing sector of day trading strategies today are undoubtedly those that involve algorithmic or high-frequency trading. These types of trading offer major advantages in speed and accuracy, provided the algorithms running them are created intelligently and tested thoroughly. This requires not just extensive technical analysis abilities but also access to the programming skills necessary to create algorithms advanced enough to perform adequately.

What Can Composer Do for Day Traders?

No day trader will ever be successful without the proper tools at their disposal. Online trading platforms like Composer offer robust tools that can make day trading easier in several ways, like offering real-time market data and historical data for backtesting. Additionally, in the case of platforms like Composer, day traders can gain access to pre-programmed trading algorithms, or the tools needed to build them without having it necessary to possess the skills needed to create their own. 

Day trading has never been for the faint hearted. It's a highly advanced collection of investment strategies that are ideal for anyone looking for very rapid growth at the expense of often immense risk. There are dozens of tools and strategies available to make it easier to get started in day trading, but selecting the right combination of these can easily spell the difference between success and failure. If you're looking for one of the best and highest-quality online trading platforms to support your day trading goals, join Composer for free today!