Day trading most commonly refers to the practice of buying and selling stocks during the day such that at the end of the day there has been no net change in position i.e. for every share of stock bought an equivalent share is sold. A gain or loss is made on the difference between the purchase and sales prices. One side effect of this style of trading is that shares are not delivered or received as there are a few days between trade and settlement.

Day trading is not necessarily more risky than any other trading activity. However, the common use of buying on margin (i.e. using borrowed funds) amplifies gains and losses such that substantial losses or gains can occur in a very short period of time. It is commonly stated that "80%" or "90%" of Day traders lose money. An analysis of the Taiwanese stock market suggests that "less than 20% of day traders earn profits net of transaction costs" ^[1].

Day trading used to be the preserve of financial firms and professionals and some savvy private investors and speculators but in recent years has become notoriously common amongst casual traders taking advantage of new facilities offered via the Internet.

The NASDAQ officially defines "pattern day trading" as placing four or more round-trip orders in one day on a regular basis.^[2] A pattern day trader is treated differently from other traders: a broker may allow margin levels as low as 25% as opposed to the usual 50% e.g. a day trader can leverage the $100 in his account to buy $400 worth of stock; a broker may require the trader maintain a minimum liquidation value e.g. if the account value falls below $25,000 no day trading is allowed.

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

History of Day trading

To understand how day trading has evolved, one must understand how stocks were traditionally bought and sold. Originally, most important US stocks were traded on the New York Stock Exchange. A trader would telephone a stockbroker, who would relay the order to a specialist on the floor of the NYSE. These specialists would each handle only one to five stocks. The specialist would match the purchaser with the seller, write up physical tickets that effectively transferred the stock, and relay the information back to the broker. 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.

During the 1970's, two important events occurred that would make day trading in stocks possible. In 1971, the NASDAQ was founded -- a virtual stock exhange on which orders were transmitted electronically. In 1975, the Securities and Exchange Commission made fixed commissions illegal, giving rise to discount brokers.

Thereafter, the systems by which stocks are traded have evolved along with the home computer and the internet. A number of Electronic Communications Networks (ECN's) began to form. These were 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 buy a certain amount of securties at a certain price (the "bid"). The first of these was Instinet. Instinet or "inet"^[3] was founded in 1969 as a way for major institutions to bypass the increasingly cumbersome and expensive NYSE, and also allowing them to trade during hours when the exchanges were closed. Ironically, early ECN's 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 reason for this was that "market makers" had very few obligations to the public. A market-maker is the NASDAQ equivalent of a NYSE specialist. It 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". A pure market-maker will not care if the price of a stock goes up or down, as it has enough stock and capital to constantly buy for less than it sells. Today there are about 500 firms who participate as market-makers on ECN's, each generally making a market in four to forty different stocks.

But absent any legal obligations, market-makers were free to offer smaller spreads on ECN's than on the NASDAQ. A small investor might have to pay a $.25 spread (e.g. he might have to pay $10.50 to buy a share of stock but could only get $10.25 to sell it), while an institution would only pay a $.05 spread (buying at $10.40 and selling at $10.35).

In 1997, the SEC adopted "Order Handling Rules" which required market-makers to publish their best bid and ask on the NASDAQ. ^[4] The existing ECN's did an about-face and began to offer their services to small investors. New brokerage firms began to emerge which specialized in serving online traders who wanted to trade on the ECN's. New ECN's also arose, most importantly Archipelago (arca) and Island (isld). Archipelago eventually became a stock exhange and in 2005 was purchased by the NSYE. (At this time, the NYSE has proposed merging Archipelago with itself, altough some resistance has arisen from NYSE members.) Commissions plummeted; in an extreme example (1000 shares of Google), in 2005 an online trader might buy $300,000 of stock at a commission of about $10, as opposed to the $3,000 commission he would have paid in 1974. Moreover, the trader would be able to buy the stock almost instantly and would get it at a cheaper price.

ECN's are in constant flux. New ones are formed, while existing ones are bought or merge. As of the end of 2005, the most important ECN's to the individual trader are Instinet (which bought Island in 2005), Archipelago (although technically it is now an exchange rather than an ECN), and The Brass Utility ("brut"), as well as the SuperDot electronic system now used by the NYSE.

This combination of factors has made day trading in stocks and stock derivatives (such as ETF's) possible. The low commission rates allow an invidivual or small firm to make a large numbers of trades during a single day. The liquidity and small spreads provided by ECN's allow an invidual to make near-instantaneous trades and to get favorable pricing. High-volume issues such as Intel or Microsoft generally have a spread of only $.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 technical 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 amounts of profits by buying these stocks in the morning and selling them in the afternoon, at 400% margin rates.

Adding to the day-trading frenzy were the enormous profits made by the "SOES bandits". (Unlike the new day traders, these individuals were highly-experienced professional traders able to exploit the arbitrage opportunity created by SOES.)

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. ^[5]

A particularly nasty incident occurred in July of 1999 when day trader Mark Barton killed his wife and two children then proceeded to visit two brokerage firms killing nine more people and wounding several others before killing himself [6][7][8].

Techniques

There are six common basic strategies by which day traders attempt to make a profit: Trend following, playing news events, range trading, scalping, technical trading, and covering spreads.

Trend following

Trend following, a strategy used in all trading time frames, assumes that stocks which have been rising steadily will continue to rise, and vice versa. The trend follower buys a stock which has been rising, or short-sells a falling stock, in the expectation that the trend will continue.

Playing News

Playing news 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).

Range Trading

A range trader watches a stock that has been rising off a support price and 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". The range trader therefore buys the stock at or near the low price, and sells (and possibly short sells) at the high.

Scalping

Scalping originally referred to spread trading. Today it has come to mean any extremely quick trade for a small profit.

Technical Trading

Technical or formula traders use mathematical formulae to decide when a stock is going to rise or fall. Most traders use technical indicators, although more experienced traders tend to use fewer of them. (In fact, some very long-time veterans do not even use charts, but buy and sell just from "reading the tape", that is, watching the bid, ask, trade, and volume numbers from a Level II screen.)

Covering Spreads

Playing the spread involves buying at the Bid price and selling at the Ask price. The numerical difference between these two prices is known as the spread. The bigger the spread, the more inefficient the market for that particular stock, and the more potential for profit. This spread is the mechanism that some large Wall Street firms use to make most of their money (as opposed to trade commissions) since the advent of online discount brokerages. To make the spread means to simply buy at the Bid price and sell at the Ask price. This procedure allows for profit even when the bid and ask don't move at all.

About 75% of all trades are to the upside -- that is, the trader buys an issue hoping its price will rise -- because of the stock market's historical tendency to rise and because there are no technical limitations on it. About 25% of equity trades, however, are short sales. 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 return of its shares at any time.

When the typical online investor places a market order to buy a stock, his broker submits this order to a market maker (MM), who then fulfills the order at the Ask price. In other words, the Ask price is the price the MM is asking for the stock. When the typical online investor places a market order to sell a stock, the broker submits the order to a MM and sells at the Bid price, i.e. what the MM is bidding for the stock.

Due to the liquidity of the modern market, orders are constantly flowing. Many times, a MM will buy a stock just to turn around and sell it to a particular broker. In fact, one of the primary purposes of the MM is to maintain liquidity in the market (among other things). Through this transaction, the MM will profit anywhere from a few cents to a whole dollar per share, in average circumstances. Over the course of a single day, a MM may fill orders for hundreds of thousands or millions of shares.

Day traders are able to capture some of the spread through buying access to Direct-Access Broker systems, rather than by trading through retail brokers. The average online investor uses a retail broker. (All of the brokerages that advertise $15, $10, or $5 commissions to the general public are retail brokers.) Through direct-access brokerage systems, day traders send their orders directly to the ECNs, instead of indirectly through brokers. ECNs put day traders on the same level as MMs.

A stop loss order is an instruction to close down a position at a certain price level. This is one of the tools used to help prevent large losses.

Views of Day Traders

Day traders, through the use of modern technology and recent regulatory changes (within the last 15 years), have cut in on the MM's business action and taken a piece of the pie for themselves. Some see this as causing frustration amongst investment banks, who are thought to vilify day traders in the press. Day traders are sometimes portrayed as "bandits" or "gamblers" which is thought to discourage others from joining in on the activity.

On the other hand, some see the phenomenon of day traders as primarily created by the stock brokerage community, in order to get people to constantly trade more stocks, and to thereby pay more commissions. These critics see this as applying to business news and stations such as CNBC, which is seen as relevant primarily to day traders.

See also

• E*Trade Financial Corp.

External links

• US government warning about the dangers of day trading
• Traders Expo - convention for day traders
• Investopedia - Traders education
• Day Trading Resources
• Trade2Win - Largest online day trading community
• Day Trading Articles, Tools and Systemsde:Daytrading

References

1. ^  On February 27, 2001, the Securities and Exchange Commission (SEC) approved amendments to National Association of Securities Dealers, Inc. (NASDВ®) Rule 2520 relating to margin requirements for day traders. The amendments become effective on September 28, 2001 and are substantially similar to amendments by the New York Stock Exchange (NYSE) to its margin rules. Although the rules relating to the handling of day trading accounts and margin requirements is extremely complex, generally an account must have at least four round-trip trades in five successive business days to become a "pattern daytrading account".
2. ^  ECN's and exchanges are usually known to traders by a three- or four-letter designator, which identifies the ECN or exchange on Level II stock screens. ECN's are identified in small letters: For example, Instinet is inet, Brass Utility is brut, Arcanet is arca, Arcaex is ARCA, Bloomberg is btrd, Island used to be isld.
3. ^  Another reform made during this period 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 MM's listed bid or ask. A defect in the system gave rise to arbitrage by a small group of traders known as the "SOES bandits", who made fortunes buying and selling small orders to market makers.
4. ^  The more cynical reader might be amused to know that Charles Mackay's classic Extraordinary Popular Delusions and the Madness of Crowds, written in 1841 about the Dutch Tulipmania of the 1600's, enjoyed a resurgence of popularity among traders.
5. ^  Barber, Brad M., Lee, Yi-Tsung, Liu, Yu-Jane and Odean, Terrance, "Do Individual Day Traders Make Money? Evidence from Taiwan" (January 2005). http://ssrn.com/abstract=529063