day trader: Definition from Answers.com

With the rapid growth of the Internet in the late 1990s, international stock markets moved online and became easily accessible to anyone with access to the World Wide Web. As a result, people were able to trade stocks directly from their own computers, a function previously performed only by stock brokers. Once people realized they could handle their own stock trades, many decided to try to make money by guessing when the ups and downs in the stock market would occur. As a result, day trading was born. The effect that the Internet has had on the stock markets cannot be emphasized enough. Commenting in Entrepreneur, Securities and Exchange Commission (SEC) Chairman Arthur Levitt estimated that in 1999, 2 5 percent of all trades were made by individuals online. That means that seven million investors participated in online trading—which is impressive considering there were none just five years earlier. And more growth is expected.

In its investigation of the new practice, the U.S. Senate Permanent Subcommittee on Investigations defined day trading as "placing multiple buy and sell orders for securities and holding positions for a very short period of time, usually minutes or a few hours, but rarely longer than a day. Day traders seek profits in small increments from momentary fluctuations in stock prices after paying commissions." In the more technical language of the National Association of Securities Dealers (NASD), day trading is "an overall trading strategy characterized by the regular transmission by a customer of intra-day orders to effect both purchase and sale transactions in the same security or securities."

The Risks of Day Trading

Basically, day trading firms differ from traditional brokerage houses, and even online brokerage companies, in one fundamental way—they offer their customers direct, electronic access to stock markets. A handful even offer real-time access, which means traders see the market just as it really is at that second. Traditional brokerages work with the customer, then place the trade orders through middlemen, called market makers. The customer is never involved directly in the trade, and it takes some time for the trade to be completed. Not so with day trading—the customer is actively involved, and trades are completed immediately. With nearly 2 million people making up to 100 stock trades per year, and 250,000 people making more than 400 trades annually, there is a large, and growing, market for the day trading firms to work with. The firms target the investors who make the most trades. Since trades can cost anywhere from $15 to $25 per trade, the day trading firm makes more money as an investor makes more trades, no matter what happens to the customer's stock. The customer can lose money, but the firm can never lose, thanks to the per trade fee.

With its "get rich quick" aura and seeming simplicity, day trading took the securities world by storm in the late 1990s. Everyone from professional stock brokers to the average Joe on the street tried to become a millionaire when stock markets soared at the end of the twentieth century. More than 100 companies provided day trading services in 2000, ranging from long-time brokers such as Charles Schwab to dot.com companies that were gone in a month. Although the total number of day traders is still only a fraction of the total number of people who invest in the stock market, James Lee of the ETA estimates that the actions of day traders may account for 10 to 15 percent of the total daily dollar volume on the Nasdaq stock exchange on any given day. In addition to being a different type of investor, the people involved in day trading treat stocks a different way. In the past, according to Fortune, the average length of time a stock share was held by an investor was two years; today, it's five months.

One of the key differences between day trading and regular stock investing is the knowledge required. In regular investing, stock brokers and others who invest spend days, even weeks, studying a particular company and learning all there is to know about it. Brokers will devote a career to one particular market segment, such as technology stocks, and much of their time is spent learning about the companies in that segment. When a regular investor makes a stock purchase, it is likely because he or she is knowledgeable about a company and expects its stock to do well in the long run—the next year to the next 20 years, perhaps.

In day trading, the investor often knows literally nothing about the companies that he or she is purchasing. "Who cares what [a company's] earnings are?" said Charles Kim of the day trading firm Swift Trade Securities in Canadian Business. "We don't." All the day trader knows is that there is some piece of information (or, often, a hunch) that has become available very recently that indicates that a certain company's stock is about to go up in the next minute, hour, or day. The day trader then purchases that stock, holds on to it until a suitable profit has been made (or, disastrously, money has been lost), then sells it. Stocks are rarely held overnight. Nothing is ever known about the company that was just traded. Essentially the day trader is gambling, betting that the next short-term price fluctuation will be in his or her favor and result in a profit.

As long as stocks were doing well, day trading was a popular, money-making activity for many people, or so it seemed. A 2000 study by the North American Securities Administrators Association, quoted in Forbes, found that "77 percent of day traders lose money. And of those who did profit, the average was just $22,000 over the space of eight months. Of the 124 accounts surveyed, only two—people, not percent—netted $100,000 or better. The highest was $160,000." And that was at a time (1998-1999) when the stock market was soaring. Now that it has come back down, there is even less money being made.

Because the real profits from day trading do not necessarily match the profits that some firms boast of in their advertisements, companies in the industry are closely scrutinized. NASD Regulation, Inc., the regulatory arm of NASD that polices the securities industry, studied 22 day trading firms in 1999 and came up with some disturbing conclusions. They found improprieties in "advertising, Regulation T and margin lending, registration of individuals, short sales, and supervision." As of early 2001, however, NASDR had only formally punished one day trading firm, fining it $25,000 for failing to properly train and certify the 14 individuals it had working as traders. Other agencies, such as the New York Stock Exchange, have begun to take action against unscrupulous day trading firms as well, and more action is expected. Several states have also conducted their own investigations of day trading firms within their borders and have taken enforcement actions against the worst offenders. However, the biggest risk to investors still seems to be simply losing money in the highly volatile stock market.

The History of Day Trading

Day trading has its origins in the birth of the computerized, over-the-counter NASD, which occurred in 1971. Fourteen years later, NASD created the Small-Order Execution System, which made it easy for individuals to execute stock trades automatically, as long as the orders were for 1,000 shares or less. Trades placed through SOES, as the system is known, bypassed the phone lines used to make most trades and placed orders in a matter of seconds, instead of minutes. While SOES users may not buy or sell the same stock during a five-minute period, there were still a group of daring investors who thought they could use SOES to make rapid stock transactions to make a great deal of money, and thus day trading was born.

The modern day trader is no longer limited to SOES. Indeed, the most popular tool for the day trader today is the electronic communication networks, or ECNs, which are internal networks set up to handle groups of customers who make large blocks of stock trades. All the members of one ECN may trade directly with other members of their network, placing buy or sell orders electronically. This has become the main tool of the day trader. To best use that tool, day traders watch the Nasdaq Level II screen religiously on their computers. The best bid on any given stock is displayed on the Nasdaq Level I screen, while the Level II screen displays all bid prices for a selected stock. This increased amount of information allows the trader to better gauge what is happening with the stock: What are the high and low bids? How many bids have been made? Are the number of bids increasing or decreasing? This information is invaluable as the day trader decides which stock to buy.

With the growth of any money-making activity comes the hangers-on, and that is true for day trading as well. There is a large industry that relies on day traders, from book and newsletter publishers to online advice columns and investment advisors. There are also training programs, on-site seminars, software, stock picking systems, and much more. All of these related industries are unregulated and full of hype, shady deals, and bad advice. It is definitely a "buyer beware" situation, but that fits in well with day trading in general.

Characteristics

Trade Frequency

Although collectively called day trading, there are many styles within day trading. Scalping is an intra-day technique that usually has the trader holding a position for a few minutes. Shaving is a method introduced by http://TradingStrategies.com which allows the trader to jump ahead by a tenth of a cent, and a full round trip (a buy and a sell order) is often completed in under one second. Instead of bidding $10.20 per share, the scalper will jump the bid at $10.201 becoming the best bid and therefore the first in line to be able to purchase the stock. When the best "Offer" is $10.21, the shaver will again jump first in line and sell a tenth of a cent cheaper at $10.209 for a profit of 0.008 of a dollar. The profits add up when using 10,000 share lots each time and the combined earnings from Rebates (read below) for creating liquidity. A day trader is actively searching for potential trading setups (that is, any stock or other financial instruments that, in the judgment of the day trader, is in a tension state, ready to accelerate in price in either direction, that when traded well has a potential for a substantial profit). The number of trades you can make per day are almost unlimited, as are the profits and losses.

Some day traders focus on very short-term trading within the trading day, in which a trade may last just a few minutes. Day traders may buy and sell many times in a trading day and may receive trading fee discounts from their broker for this trading volume.

Some day traders focus only on price momentum, others on technical patterns, and still others on an unlimited number of strategies they feel can be profitable.

Some day traders exit positions before the market closes to avoid any and all unmanageable risks --- negative price gaps (differences between the previous day's close and the next day's open bull price) at the open --- overnight price movements against the position held. Other traders believe they should let the profits run, so it is acceptable to stay with a position after the market closes.^[1]

Day traders sometimes borrow money to trade. This is called margin trading. Since margin interests are typically only charged on overnight balances, the trader pays no fees for the margin benefit, although they still run the risk of a Margin call. The margin interest rate is usually based on the Broker's call.

Profit and Risks

Because of the nature of financial leverage and the rapid returns that are possible, day trading can be either extremely profitable or extremely unprofitable, and high-risk profile traders can generate either huge percentage returns or huge percentage losses. Some day traders manage to earn millions per year solely by day trading.^[2]

Because of the high profits (and losses) that day trading makes possible, these traders are sometimes portrayed as "bandits" or "gamblers" by other investors. Some individuals, however, make a consistent living from day trading.

Nevertheless day trading can be very risky, especially if any of the following is present while trading:

trading a loser's game/system rather than a game that's at least winnable,
trading with poor discipline (ignoring your own day trading strategy, tactics, rules),
inadequate risk capital with the accompanying excess stress of having to "survive",
incompetent money management (i.e. executing trades poorly).^[3]

The common use of buying on margin (using borrowed funds) amplifies gains and losses, such that substantial losses or gains can occur in a very short period of time. In addition, brokers usually allow bigger margins for day traders. Where overnight margins required to hold a stock position are normally 50% of the stock's value, many brokers allow pattern day trader accounts to use levels as low as 25% for intraday purchases. This means a day trader with the legal minimum $25,000 in his or her account can buy $100,000 worth of stock during the day, as long as half of those positions are exited before the market close. Because of the high risk of margin use, and of other day trading practices, a day trader will often have to exit a losing position very quickly, in order to prevent a greater, unacceptable loss, or even a disastrous loss, much larger than his or her original investment, or even larger than his or her total assets.

History

Originally, the most important U.S. stocks were traded on the New York Stock Exchange. A trader would contact a stockbroker, who would relay the order to a specialist on the floor of the NYSE. These specialists would each make markets in only a handful of stocks. The specialist would match the purchaser with another broker's seller; write up physical tickets that, once processed, would effectively transfer the stock; and relay the information back to both brokers. 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.

One of the first steps to make day trading of shares potentially profitable was the change in the commission scheme. In 1975, the United States Securities and Exchange Commission (SEC) made fixed commission rates illegal, giving rise to discount brokers offering much reduced commission rates.

Financial Settlement

Financial settlement periods used to be much longer: Before the early 1990s at the London Stock Exchange, for example, stock could be paid for up to 10 working days after it was bought, allowing traders to buy (or sell) shares at the beginning of a settlement period only to sell (or buy) them before the end of the period hoping for a rise in price. This activity was identical to modern day trading, but for the longer duration of the settlement period. But today, to reduce market risk, the settlement period is typically three working days. Reducing the settlement period reduces the likelihood of default, but was impossible before the advent of electronic ownership transfer.

Electronic Communication Networks

The systems by which stocks are traded have also evolved, the second half of the twentieth century having seen the advent of Electronic Communication Networks (ECNs). These are 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 to buy a certain amount of securities at a certain price (the "bid").

ECNs and exchanges are usually known to traders by a three- or four-letter designators, which identify the ECN or exchange on Level II stock screens. The first of these was Instinet (or "inet"), which was founded in 1969 as a way for major institutions to bypass the increasingly cumbersome and expensive NYSE, also allowing them to trade during hours when the exchanges were closed. Early ECNs 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 next important step in facilitating day trading was the founding in 1971 of NASDAQ --- a virtual stock exchange on which orders were transmitted electronically. Moving from paper share certificates and written share registers to "dematerialized" shares, computerized trading and registration required not only extensive changes to legislation but also the development of the necessary technology: online and real time systems rather than batch; electronic communications rather than the postal service, telex or the physical shipment of computer tapes, and the development of secure cryptographic algorithms.

These developments heralded the appearance of "market makers": the NASDAQ equivalent of a NYSE specialist. A market maker 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". It is of no importance to the market-maker whether 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 ECNs, each generally making a market in four to forty different stocks. Without any legal obligations, market-makers were free to offer smaller spreads on ECNs than on the NASDAQ. A small investor might have to pay a $0.25 spread (e.g. he might have to pay $10.50 to buy a share of stock but could only get $10.25 for selling it), while an institution would only pay a $0.05 spread (buying at $10.40 and selling at $10.35).

Technology Bubble (1997–2000)

In 1997, the SEC adopted "Order Handling Rules" which required market-makers to publish their best bid and ask on the NASDAQ. 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.

The existing ECNs began to offer their services to small investors. New brokerage firms which specialized in serving online traders who wanted to trade on the ECNs emerged. New ECNs also arose, most importantly Archipelago ("arca") and Island ("isld"). Archipelago eventually became a stock exchange and in 2005 was purchased by the NYSE. (At this time, the NYSE has proposed merging Archipelago with itself, although some resistance has arisen from NYSE members.) Commissions plummeted. To give an extreme example (trading 1000 shares of Google), an online trader in 2005 might have bought $300,000 of stock at a commission of about $10, compared to the $3,000 commission the trader would have paid in 1974. Moreover, the trader was able in 2005 to buy the stock almost instantly and got it at a cheaper price.

ECNs are in constant flux. New ones are formed, while existing ones are bought or merged. As of the end of 2006, the most important ECNs to the individual trader were:

Instinet (which bought Island in 2002),
Archipelago (although technically it is now an exchange rather than an ECN),
the Brass Utility ("brut"), and
the SuperDot electronic system now used by the NYSE.

The evolution of average NASDAQ share prices between 1994 and 2004

This combination of factors has made day trading in stocks and stock derivatives (such as ETFs) possible. The low commission rates allow an individual or small firm to make a large number of trades during a single day. The liquidity and small spreads provided by ECNs allow an individual to make near-instantaneous trades and to get favorable pricing. High-volume issues such as Intel or Microsoft generally have a spread of only $0.01, 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 technological 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 profits 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" who, unlike the new day traders, 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, although obviously it was possible to have made a fortune during that time by shorting or playing on volatility.

Techniques

The following are several basic strategies by which day traders attempt to make profits. Besides these, some day traders also use contrarian (reverse) strategies (more commonly seen in algorithmic trading) to trade specifically against irrational behavior from day traders using these approaches.

Some of these approaches require shorting stocks instead of buying them normally: 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 the return of its shares at any time. Some of these restrictions (in particular the uptick rule) don't apply to trades of stocks that are actually shares of an exchange-traded fund (ETF).

The Securities and Exchange Commission removed the uptick requirement for short sales on July 6, 2007.^[4]

Trend Following

Main article: Trend following

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

Contrarian Investing

Main article: Contrarian investing

Contrarian investing is a market timing strategy used in all trading time-frames. It assumes that financial instruments which have been rising steadily will reverse and start to fall, and vice versa with falling. The contrarian trader buys an instrument which has been falling, or short-sells a rising one, in the expectation that the trend will change.

Range Trading

Range trading, or range-bound trading, is a trading style in which stocks are watched that have either been rising off a support price or 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", which is the opposite of trending. The range trader therefore buys the stock at or near the low price, and sells (and possibly short sells) at the high. A related approach to range trading is looking for moves outside of an established range, called a breakout (price moves up) or a breakdown (price moves down), and assume that once the range has been broken prices will continue in that direction for some time.

Scalping

Main article: scalping (trading)

Scalping was originally referred to as spread trading. Scalping is a trading style where small price gaps created by the bid-ask spread are exploited. It normally involves establishing and liquidating a position quickly, usually within minutes or even seconds.

Scalping highly liquid instruments for off the floor day traders involves taking quick profits while minimizing risk (loss exposure). It applies technical analysis concepts such as over/under-bought, support and resistance zones as well as trendline, trading channel to enter the market at key points and take quick profits from small moves. The basic idea of scalping is to exploit the inefficiency of the market when volatility increases and the trading range expands.

Rebate Trading

Main article: Rebate trading (trading)

Rebate Trading is an equity trading style that uses ECN rebates as a primary source of profit and revenue. Most ECNs charge commissions to customers who want to have their orders filled immediately at the best prices available, but the ECNs pay commissions to buyers or sellers who "add liquidity" by placing limit orders that create "market-making" in a security. Rebate traders seek to make money from these rebates and will usually maximize their returns by trading low priced, high volume stocks. This enables them to trade more shares and contribute more liquidity with a set amount of capital, while limiting the risk that they will not be able to exit a position in the stock. Rebate trading was pioneered at Domestic Securities, founded by Harvey Houtkin the author of "Soes Bandits". Later this strategy was taken from Domestic Securities to Momentum Securities over the MarketXT ECN with the MPID LSPD. The rebate trading group at Momentum Securities / Tradescape was responsible for the $280 million buyout from online trading giant E*Trade.

News Playing

News playing 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). Determining whether news is "good" or "bad" must be determined by the price action of the stock, because the market reaction may not match the tone of the news itself. The most common cause for this is when rumors or estimates of the event (like those issued by market and industry analysts) were already circulated before the official release, and prices have already moved in anticipation---the news is already priced in the stock.

Price action

Keeping things simple can also be an effective methodology when it comes to trading. There are groups of traders known as "Price Action Traders" who are a form of technical traders that rely on technical analysis but do not rely on conventional indicators to point them in the direction of a trade or not. These traders rely on a combination of price movement, chart patterns, volume, and other raw market data to gauge whether or not they should take a trade. This is seen as a "simplistic" and "minimalist" approach to trading but is not by any means easier than any other trading methodology. It requires a sound background in understanding how markets work and the core principles within a market, but the good thing about this type of methodology is it will work in virtually any market that exists (Stocks, Forex, Futures, Gold, Oil, etc.).

Artificial Intelligence

As computers gain processing power (see Moore's law) it has become easier to leverage this to evaluate the market on a deeper level. A method of using Artificial Intelligence to weigh news events was created by http://www.warpedai.com. This method tracks words and phrases in news articles, and then takes the change in price as an action indicating whether the word or phrase is positive or negative. Over years, hundreds of uses of each phrase would give words a strong positive or negative relationship. This technology can then be leveraged to explore the historical significance of a news item.

Cost

Trading Equipment

Some day trading strategies (including scalping and arbitrage) require relatively sophisticated trading systems and software. This software can cost up to $45,000 or more. Many day traders use multiple monitors or even multiple computers to execute their orders. Some use real time filtering software which is programmed to send stock symbols to a screen which meet specific criteria during the day, such as displaying stocks that are turning from positive to negative.

A fast Internet connection, such as broadband, is essential for day trading.

Brokerage

Day traders do not use retail brokers because they are slower to execute trades and charge higher commissions than direct access brokers, who allow the trader to send their orders directly to the ECNs. Direct access trading offers substantial improvements in transaction speed and will usually result in better trade execution prices (reducing the costs of trading). Outside the US, day traders will often use CFD or financial spread betting brokers for the same reasons.

Commission

Commissions for direct-access brokers are calculated based on volume. The more you trade, the cheaper the commission is. While a retail broker might charge $10 or more per trade regardless of the trade size, a typical direct-access broker may charge as little as $0.004 per share traded, or $0.25 per futures contract. A scalper can cover such costs with even a minimal gain.

As for the calculation method, some use pro-rata to calculate commissions and charges, where each tier of volumes charge different commissions. Other brokers use a flat-rate, where all commissions charges are based on which volume threshold one reaches.

Spread

Main article: Bid and ask

The numerical difference between the bid and ask prices is referred to as the bid-ask spread. Most worldwide markets operate on a bid-ask-based system.

The ask prices are immediate execution (market) prices for quick buyers (ask takers) while bid prices are for quick sellers (bid takers). If a trade is executed at quoted prices, closing the trade immediately without queuing would not cause a loss because the bid price is always less than the ask price at any point in time.

The bid-ask spread is two sides of the same coin. The spread can be viewed as trading bonuses or costs according to different parties and different strategies. On one hand, traders who do NOT wish to queue their order, instead paying the market price, pay the spreads (costs). On the other hand, traders who wish to queue and wait for execution receive the spreads (bonuses). Some day trading strategies attempt to capture the spread as additional, or even the only, profits for successful trades.

Market Data

Market data is necessary for day traders, rather than using the delayed (by anything from 10 to 60 minutes, per exchange rules^[5]) market data that is available for free. A real-time data feed requires paying fees to the respective stock exchanges, usually combined with the broker's charges; these fees are usually very low compared to the other costs of trading. The fees may be waived for promotional purposes or for customers meeting a minimum monthly volume of trades. Even a moderately active day trader can expect to meet these requirements, making the basic data feed essentially "free."

In addition to the raw market data, some traders purchase more advanced data feeds that include historical data and features such as scanning large numbers of stocks in the live market for unusual activity. Complicated analysis and charting software are other popular additions. These types of systems can cost from tens to hundreds of dollars per month to access.

Regulations and Restrictions

Day trading is considered a risky trading style, and regulations require brokerage firms to ask whether the clients understand the risks of day trading and whether they have prior trading experience before entering the market.

Pattern Day Trader

Main article: Pattern day trader

In addition, NASD and SEC further restrict the entry by means of "pattern day trader" amendments. Pattern day trader is a term defined by the SEC to describe any trader who buys and sells a particular security in the same trading day (day trades), and does this four or more times in any five consecutive business day period. A pattern day trader is subject to special rules, the main rule being that in order to engage in pattern day trading the trader must maintain an equity balance of at least $25,000 in a margin account.^[6]

External links

U.S. Securities and Exchange Commission on day trading

Notes and references

^ Sale, Robert (2001). Trading Strategies for Direct Access Trading: Making the Most Out of Your Capital
^ Day trader Paul Rotter is profiled in Trader Monthly.
^ U.S. government warning about the dangers of day trading
^ Investopedia. "Uptick Rule". http://www.investopedia.com/terms/u/uptickrule.asp.
^ "Exchange Requirements for Delayed Market Data"
^ Website that explains NASD Rule 2520 the Pattern Day Trader Rule

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