Day Trading

What is Day Trading?

Day trading is the practice of buying and selling a security on the same day. That is, an investor enters and exits the transaction on the same trading day, and no open positions are maintained overnight. It essentially occurs in any market; however, it is more prevalent in the stock and foreign exchange markets. It entails using large amounts of leverage to make the most of price fluctuations, be it a short or long trade. Given gains are made on swift price changes, investors seek out volatile and highly liquid assets.

Day traders base their decisions on numerous indicators, news, scheduled announcements (e.g. corporate earnings, interest rate changes) while trying to predict future market inefficiencies that can be exploited for capital gain. Meanwhile, day traders try to rely as little as possible on their gut feeling and emotions, for that reason money invested is often the amount they can afford to lose.

The most common trading strategies range from making numerous small profits on various small price changes (Scalping), to take advantage of the volatility created by news events (News-Based Trading), all the way to using algorithms to identify and make the most of small market inefficiencies (High-Frequency Trading).

Day trading can be traced back to 1867, before computers, the internet or even electricity existed. Stock markets used the telegraph’s communication technology to create the ticker tape, the earliest electrical dedicated financial communications medium, which allowed for brokers’ transactions to be communicated. In the past, those who were able to day trade were brokers working for large institutions, which managed the firm’s money, as well as that of its clients. They had access to a direct trading line, a trading desk, great amounts of capital and highly advanced analytical software. Nevertheless, the position of day trading has extended to anyone interested, though with a more limited know-how and access to financial tools, as platforms now offer lower fees.

Different types of strategies

Each trader usually creates his strategy based on one simple criteria: Risk. As financial markets teach us every day, trading on riskier approaches tend to end up either in disastrous trades or in absolute jackpots or, on the off chance the market shows low levels of volatility, the gains/losses can be closer to zero. However, professional and retail traders tend to focus more on volatile and high beta’s assets that, at the end of the day, can turn a soft overall market movement into a considerable profit return for the portfolio. Traders do have to consider the need to top commission fees so that the high number of trades won’t eat up the gains and leave them holding nothing.

Taking these facts into account, traders choose the strategy of which they feel mostly suits their reach. So, components as the time, money willing to involve on the portfolios, experience in trading, and the knowledge behind market movements may drive different approaches from traders.

Arbitrage Trading:

Arbitrage is solely the act of purchasing and selling a financial instrument by exploiting market inefficiencies.

Take for example the simplest arbitrage trade possible, imagine you hold Apple stocks and you realize that it is selling for $118 on the NYSE and it has a bidding price of $117.5 on the LSE. With this you could incur in free-of-risk transactions from one Stock Exchange to another until the market gets corrected, which until then, profit would be assured. However, arbitrage opportunities are said to have gone extinct for retail investors due to the highly computerized financial software, which when any dysregulations like this occur, are promptly put to an end by the fastest market-maker that sees it and takes advantage of it with the use of advanced algorithms.

Swing Trading:

Swing trading is a type of trading that implies seeking for a big chunk of a potential price movement, instead of settling for small movements caused from natural volatility. Due to the end goal that this strategy aims to achieve, it usually forces the trader to hold the security overnight and to sell it in the following days. This method highly relies more on technical analysis rather than on fundamental analysis, considering the trader incurs in the purchase and selling of the security regardless of what he believes the intrinsic value of the asset is. A swing trader supports his decisions by looking for common patterns, moving average crossovers, cup-and-handle, as many other multi-day chart patterns in order to set the buying price and then the chosen Stop Loss/Take Profit values.

News Trading

As the name suggests, news trading strategies implies the trader to make its judgement of pursuing a transaction based on news and rumors, either before they are announced or after. This type of strategy does not require the trader to undergo any detailed technical analysis but rather to focus its trade on the qualitative side of the fundamentals of the company, thus, in this case, to know if the announcement or the new will meet the markets expectations or, if on the other hand, might change the investors’ opinion of the companies’ value.

Merger Arbitrage

Often referred to as Hedge Fund strategy, this strategy comes from the purchasing and selling of a stock that is supposed to be acquired by a second company at a higher price. This type of strategy involves calculating the probability that either the merger is going to be settled at that given price, as it will occur at the time expected.

One controversial example in the Portuguese stock market’s sphere was the “Benfica’s takeover bid” (OPA do Benfica). Benfica filed in for a takeover bid on its “SAD” in November 2019, by willingly acquire about 30% of its shares for a price of €5, when its stock was at the time valued at €2.71. Traders soon pumped up the stock to a value close to the acquisition one, only to see that acquisition takeover overruled by the Portuguese Securities and Exchange Commission a few months after.

Why is it so controversial?

Day trading is regarded as one of the riskiest ways to invest your money in financial markets nowadays. There is still a general idea that this type of trading is just gambling and a scheme to make bulky profits within days. Furthermore, most experienced asset managers and financial advisors have a negative opinion regarding day trading stating that the risks almost never justify the gains received. When we long at the long-turn, day trading practices tend to underperform traditional investment practices. It is true that it often includes leveraged positions that can make traders lose much more than they initially invested, and this often happens. Although traders are only forced to show their gains and losses to IRS, several studies and market research data show that their success rate is very low, only a small percentage managing to consistently deliver relevant gains, considering the high amount of brokerage fees they pay.

Advantages of Day Trading

Although day trading practices are shown to be risky, from what we saw earlier, they are quite common today and there are reasons for it. The most advertised by day traders is the huge gains that they can make in relatively shorter periods of time. Despite depending on the amount of money that a trader is willing to risk at each trading session, the leverage mechanisms available can transform small investment sums into robust sums of money. This makes a lot of day traders believe they will be part of the small portion that is able to beat the market.

Final Thoughts

Day Trading is definitively risky by itself, it requires a filled margin account to start with and any potential profit is already cut by the brokerage fees of making many trades every day (this burden will depend on the brokerage firm). Data shows that most day traders lose money and a high percentage of the ones that have any gains have a small profit margin. With all this information in mind and considering the inherent risk, it is a legitimate way to make a significant return with low-enough initial capital and in a few days or weeks. Day trading is not for the faint of heart and is only advisable with the right market information and experience in financial markets. It ultimately falls on each investor to decide if the reward is worth the risk.