Day Trading Risks
Most people buy stocks for the long term. They’re hoping that over time, the stock’s value will grow as the overall economy grows. Day traders, on the other hand, buy and sell stocks, foreign currencies, and other securities within the same day. They aim to capitalize on small changes in stock value over the course of hours and minutes.
Day trading is not new, but the internet and online brokerages have made it more accessible to average investors. Companies hoping to sell training sessions or brokerage access often pitch day trading to newcomers as a type of get-rich-quick scheme—maybe even a get-rich-in-your-pajamas scheme.
In reality, there’s no guarantee that you’ll earn money and there are a lot of ways to lose money when day trading. It may only be significantly profitable for a minority of traders. That said, day trading is a legitimate practice. Here’s what it involves.
The fundamentals of day trading
Day traders look for stocks that are both volatile and liquid. Volatility means the stock price moves up and down significantly over a sustained period. These swings are what day traders bet on to make money—for example, by buying at the “trough” of the day, when stock prices are at their lowest, and selling at the peak. Day traders may target volatile stocks with a lot of daily movement, such as tech stocks. By contrast, day traders might take little interest in a stock such as a staid utility company that barely budges all day.
Liquidity means a stock trades frequently and is therefore easy to buy and sell. That’s important to day traders, who rely on speedy transactions. A highly liquid stock is less likely to experience an outsized effect from day traders’ constant churn of buying and selling, which could otherwise affect the price. Day traders can use a formula called the trade volume index to gauge the amount of money that flows in and out of a particular stock.
Many day traders look to stocks called group followers, which are stocks that tend to follow the pattern of other companies in their sector. A trader who closely observes sector changes can try to anticipate how a stock will perform. Other traders make money on contrarian stocks that seem to do the opposite of their sector.
Potential pitfalls of day trading
Day trading presents a number of risks and pitfalls, including the following:
Timing the market: Day traders stay laser-focused on market developments, trying to notice changes that other investors are missing. For example, they might decide that a stock is under-valued at the market’s opening bell—in the hope that other investors haven’t noticed a news development that could boost the company’s earnings. The trader buys the stock, betting that by the end of the day, other investors will wise up and drive the price higher. That’s when they sell. Undervalued stocks are a classic example of a market inefficiency; aiming to buy and sell them opportunistically is called market timing.
But trying to anticipate how the stock market will behave—and betting against the crowd—is inherently risky. Generally speaking, people aren’t good at predicting the future. And most economists believe that over time, markets are efficient because the bulk of investors will eventually take all the important information about a stock into consideration.
Investors who are day trading to the exclusion of a long-term investment plan may miss out on the balance of risk and reward they would achieve with a properly diversified long-term portfolio. Stash recommends investing regularly for the long-term in order to build a solid financial future.
A diversified portfolio holds a variety of investments—including stocks, bonds, mutual funds and exchange-traded funds (ETFs)—that aren’t subject to the same market risks. When an individual investment is down, others may be up, helping balance out the impact of the poor performer. By focusing on individual investments, day traders can miss out on this benefit.
Risks of short selling: Another key technique used by day traders is short selling. This tactic involves borrowing shares from a broker, selling them to someone else, and betting that prices will drop during the day. At that point, the investor buys back the shares at the cheaper price, returns them to the broker—and pockets the difference (minus interest charged by the broker).
Short selling requires what’s called a margin account with a broker. There are lots of SEC rules and limitations on margin accounts—and plenty of risk. If the borrowed stock gains instead of losses, the investor is in the hole for the cash.
Lack of professional advantages: Most professional day traders work for an institution like a bank or brokerage, and have access to sophisticated data on the stock market. The average investor may become an astute trader through careful practice and personal discipline. But they won’t have the financial and analytical resources of a large institution. What’s more, they may not have the training to help them make rational investments and avoid costly mistakes fueled by emotions.
Small size: Day traders capitalize on relatively small price movements, so individual gains and losses can be minuscule. That might seem fine for amateur traders who are just trying day trading for fun with some expendable cash. The trouble is, all those trades cost money in the form of commissions to brokers, which can eat into small gains.
That’s why serious day traders move lots of cash, every day, in an attempt to to scoop up serious gains. (Brokers compete for high-volume traders by discounting commissions.) Of course, big gains can quickly turn into big losses. That’s why high volume trading presents an enormous risk.
Chances of day trading success
Can you be a successful day trader? Well, one rigorous academic study of 116 day traders over 18 months found that only 35.6 percent made a profit after expenses. The best trader raked in more than $197,000; the worst lost more than $748,000. The average net profit? Just $750. The risk might outweigh the reward in this case.
The bottom line
Remember that day trading is not a casual job: It requires commitment and discipline. Avoid day trading with your retirement savings or funds you’ve set aside for other important goals. Ultimately, investing is a long-term endeavor. Successful investment plans can be built with your specific goals in mind, as well as your time horizon and risk tolerance. That means having a diversified portfolio that balances risks and rewards—factors that day trading doesn’t account for.