Successful traders have to move fast, but they don't have to think fast. Why? Because they've developed a trading strategy in advance, along with the discipline to stick to it. It is important to follow your formula closely rather than try to chase profits. Don't let your emotions get the best of you and make you abandon your strategy. Bear in mind a mantra of day traders: plan your trade and trade your plan.
Day trading takes a lot of practice and know-how and there are several factors that can make it challenging.
First, know that you're going up against professionals whose careers revolve around trading. These people have access to the best technology and connections in the industry. That means they're set up to succeed in the end. If you jump on the bandwagon, it usually means more profits for them.
Next, understand that Uncle Sam will want a cut of your profits, no matter how slim. Remember that you'll have to pay taxes on any short-term gains—investments that you hold for one year or less—at the marginal rate. An upside is that your losses will offset any gains.
Also, as a beginning day trader, you may be prone to emotional and psychological biases that affect your trading—for instance, when your own capital is involved and you're losing money on a trade. Experienced, skilled professional traders with deep pockets are usually able to surmount these challenges.
A study by the Securities and Exchange Commission revealed that traders usually lose 100% of their funds within a year.
Day traders try to make money by exploiting minute price movements in individual assets (stocks, currencies, futures, and options). They usually leverage large amounts of capital to do so. In deciding what to buy—a stock, say—a typical day trader looks for three things:
Liquidity. A security that's liquid allows you to buy and sell it easily, and, hopefully, at a good price. Liquidity is an advantage with tight spreads, or the difference between the bid and ask price of a stock, and for low slippage, or the difference between the expected price of a trade and the actual price.
Volatility. This is a measure of the daily price range—the range in which a day trader operates. More volatility means greater potential for profit or loss.
Trading volume. This is a measure of the number of times a stock is bought and sold in a given time period. It's commonly known as the average daily trading volume. A high degree of volume indicates a lot of interest in a stock. An increase in a stock's volume is often a harbinger of a price jump, either up or down.
Once you know the stocks (or other assets) you want to trade, you need to identify entry points for your trades. Tools that can help you do this include:
Real-time news services: News moves stocks, so it's important to subscribe to services that alert you when potentially market-moving news breaks.
ECN/Level 2 quotes: ECNs, or electronic communication networks, are computer-based systems that display the best available bid and ask quotes from multiple market participants and then automatically match and execute orders. Level 2 is a subscription-based service that provides real-time access to the Nasdaq order book. The Nasdaq order book has price quotes from market makers in every Nasdaq-listed and OTC Bulletin Board security.
Intraday candlestick charts: Candlesticks provide a raw analysis of price action. More on these later.
Define and write down the specific conditions in which you'll enter a position. For instance, buy during uptrend isn't specific enough. Instead, try something more specific and testable: buy when the price breaks above the upper trendline of a triangle pattern, where the triangle is preceded by an uptrend (at least one higher swing high and higher swing low before the triangle formed) on the two-minute chart in the first two hours of the trading day.
Once you have a specific set of entry rules, scan more charts to see if your conditions are generated each day. For instance, determine whether a candlestick chart pattern signals price moves in the direction you anticipate. If so, you have a potential entry point for a strategy.
Next, you'll need to determine how to exit your trades.
There are multiple ways to exit a winning position, including trailing stops and profit targets. Profit targets are the most common exit method. They refer to taking a profit at a predetermined price level. Some common profit target strategies are:
In many cases, you will want to sell an asset when there is decreased interest in the stock as indicated by the ECN/Level 2 and volume. The profit target should also allow for more money to be made on winning trades than is lost on losing trades. If your stop-loss is $0.05 away from your entry price, your target should be more than $0.05 away.
Free Stock Market TrainingJust as with your entry point, define exactly how you will exit your trades before you enter them. The exit criteria must be specific enough to be repeatable and testable.
Day Trading Charts and Patterns
Three common tools day traders use to help them determine opportune buying points are:
Candlestick chart patterns, including engulfing candles and dojis
Other technical analysis, including trendlines and triangles
There are many candlestick setups a day trader can look for to find an entry point. If followed properly, the doji reversal pattern (highlighted in yellow in the chart below) is one of the most reliable ones.
A volume spike on the doji candle or the candles immediately following it, which can indicate that traders are supporting the price at this level
A volume spike on the doji candle or the candles immediately following it, which can indicate that traders are supporting the price at this level
Prior support at this price level such as the prior low of day (LOD) or high of day (HOD)
Level 2 activity, which will show all the open orders and order sizes
If you use these three confirmation steps, you may determine whether or not the doji is signaling an actual turnaround and a potential entry point.
Chart patterns also provide profit targets for exits. For example, the height of a triangle at the widest part is added to the breakout point of the triangle (for an upside breakout), providing a price at which to take profits.
It's important to define exactly how you'll limit your trade risk. A stop-loss order is designed to limit losses on a position in a security.
For long positions, a stop-loss can be placed below a recent low and for short positions, above a recent high. It can also be based on volatility.
For example, if a stock price is moving about $0.05 a minute, then you might place a stop-loss order $0.15 away from your entry to give the price some space to fluctuate before it moves in your anticipated direction.
In the case of a triangle pattern, a stop-loss order can be placed $0.02 below a recent swing low if buying a breakout, or $0.02 below the pattern.
You could also set two stop-loss orders: