What is day trading?
"Day trading" is the buying and selling of stocks on the same day in an attempt to profit from short-term price movements. Typical day traders try to ride the momentum of a stock and then sell it before the stock price changes its direction. They often execute "buy and sell" or round-trip transactions in a single day, and rarely hold open positions overnight to avoid overnight market risk. This is often done on margin in a bid to reap higher profits through leverage, but raises the risk of higher losses.
Things to know
Day trading is a risky, speculative activity. It is not suitable for someone of scarce financial resources, low risk tolerance, limited investment experience and trading skills. Before engaging in day trading, you must know the following:
- Day trading involves high investment risks. In order to make intra-day profits, day traders usually trade on stocks which are highly volatile, especially those penny or small-cap stocks. Consequently, the investment risks involved are particularly high.
- Day trading may result in large brokerage commissions. Despite the lower commissions charged by some brokers, day traders have to trade frequently and pay commissions for each trade. The total daily commissions may deepen losses or significantly reduce earnings.
- Day trading on margin may magnify your loss. When leveraging a position by margin loans, the loss would be magnified if the stake declines in value. In addition, you may be forced to sell your stocks on a margin call. Such forced liquidation may result in losing more than your initial investment.
- Day trading is especially vulnerable to suspension of trading. Some day traders buy a stock without the backing of the required amount of capital, hoping that the stock can be sold for gains on the same day. This is in effect a way of trading on margin which involves high leverage. If the stock purchased is suddenly suspended from trading, the day trader will be forced to hold the position, and may be exposed to liquidity stress and any uncertainty arising from the suspension.
- Claims of benefits from day trading could be misleading. Some advertisements about day trading only emphasise the potential benefits but not the risks. Be aware of misleading and unsubstantiated claims of quick money, low risk, low commissions and fast execution.
- Day trading requires knowledge of the stock market. Unlike gambling, "genuine" day trading requires in-depth knowledge of the stock market and capability to compete with professional, sophisticated traders. In a nutshell, day trading is not for novice investors.
- Day traders may overlook the importance of fundamentals. Day traders usually trade on stock price momentum, regardless of the fundamental factors of the stock. The inherent risk is buying into stocks with seemingly strong momentum but poor fundamentals.
- Day trading could become an addiction. Without taking an appropriate attitude, day trading may metamorphose into a form of gambling. Anyone who is prone to gambling addiction could be fatally hooked.
Before engaging in day trading, investors should appreciate the risks involved and have realistic expectation on the "success rate". Howard Davies, Chairman, Financial Services Authority warns investors, "70% of day traders in the US lose money and it is important that people are aware of the risks and understand the nature of the expenses they will need to cover before any possibility of making a profit."