Know the Realities of Day Trading Before You Start
Is there anything more appealing than making a quick buck through a smart stock pick?
If you’ve had several great trades you might be thinking about quitting your job to become an independent day trader — maybe even working part-time from home in shorts and T-shirt.
Day trading is exciting, and the rewards can appear tempting. But when you day trade, you’re turning established wealth-building principles upside down. There are reasons why few day traders — independent or otherwise — do well enough to retire on their trading profits.
Let’s look at the realities of day trading.
Daily Stock Returns Are Hard to Predict
Long-term investors do well because decades of market history will show that markets are predictable. If you follow certain rules, such as being well diversified, keeping costs low and staying fully invested in the stock market long enough, you are likely (but not guaranteed) to make money.
The longer you allow the stock market to do its “magic,” the better your odds become.
Once you look at a long enough history of daily stock returns, the odds of any stock being up or down on any given day come close to 50/50, which is like a coin toss. The odds of being “right” on one toss is 50%.
But the odds of being right four times in a row drops to a little bit better than one in 16, or 6.25%. Yikes.
Those risks can be multiplied by leverage. In their quest for higher profits, a trader can borrow multiples of their equity to take large positions.
For example, a trader with $25,000 to invest might borrow $50,000 from their trading firm to hold a $75,000 portfolio. If the trader is right, then the gain is four times what it would have been without the borrowing. But when wrong, that $25,000 takes four times the hit. That increased risk makes it far more likely the account can go to zero.
It’s true stocks tend to go up more than down, but the shorter the time you hold a stock, the more random it will appear.
That’s why professionals call market returns as a “random walk with an upward drift.” Want to picture that? Imagine the path of someone who’s had too much to drink trying to walk home.
We Fool Ourselves Into Seeing Patterns That Aren’t There
So you see a stock tracing out a pattern that worked before. Does that mean the stock will act the same way this time? Not necessarily.
We humans are smart, but sometimes — far too often — we outsmart ourselves by seeing patterns when what’s really happening is by chance, or isn’t as trustworthy as what we first think.
A stock that went up yesterday won’t automatically go up again. It might plateau or even reverse itself (that’s that pesky random walk). Even the best-performing stocks don’t go straight up.
Relying on patterns may even lead to that worst-case scenario of being “whipsawed,” when you get in at the wrong time, then get out, only to see the stock reverse itself again.
It’s one of the mistakes beginners can make, but even professionals who use price patterns on charts get whipsawed occasionally. They protect themselves by investing only a small portion of their total portfolios into any one idea.
One of the most dangerous patterns we tend to follow is a belief in our own abilities.
We tend to be overconfident in our opinions and put too much at risk in any one trade. A string of winning trades can get fool us into thinking we’re incredibly talented at trading or even born under the right sign, when that winning streak was just dumb chance that, sooner or later, will reverse itself.
Day Trading Is Expensive
Traders often spend fortunes on expensive computer equipment and data services that help them analyze the markets. But that’s only a start.
Other Expenses Related to Day Trading
Here are some other expenses traders can have:
- Subscriptions to an endless list of newsletters.
- Seminars that may or may not be useful, let alone legitimate. Charlatans abound in the hunt for day-trading customers.
- Annual account fees and commissions. These are easily understood, and it’s possible to shop around for the best deals.
- Hidden costs such as margin rates or fees to borrow a stock to sell short.
Another hidden cost is the difference between the price you pay to buy a stock and what you could receive for selling it that same instant, known as the bid-ask spread. If you invest in thinly-traded stocks, that difference can pile up the more you trade.
Long-term investors pay lower commissions per portfolio dollar, don’t need as much computing power and can get satisfactory results simply by applying easy-to-understand principles and being patient.
Who Are the Successful Day Traders?
With millions of people investing in stocks, there are bound to be a few who do very well. Most are professionals who work at firms that can manage risk and spot opportunities far more quickly than those of us with retail brokerage accounts.
Pros equipped with lightning-quick access to market data can exploit even those momentary blips worth fractions of a penny per share. But they have computing power, data access and data scientists, too.
Other traders might find a strategy that can work, but it’s very rare for those “trading systems” to be successful over the long term because the markets evolve rapidly. Those sorts of people are usually quick to publish (start selling their great systems), but also quick to perish (lose their customers a ton of money).
If You Still Want To Try Day Trading
If, after all these warnings, you still want to trade, first, try a simulated account where you’re not risking real money. Here’s how.
Skill-Building Challenge No. 1
- Keep a journal where you write down why you bought a stock, why you sold it, and what you think went right or wrong.
- Try investing only a small amount of simulated money into each idea.
- Then, and this is the hard part, keep doing that through both a market trending up (which makes buying stock look easy) and also when it’s trending down.
After you’ve tried a simulated account, here’s your next day trading challenge:
Skill-Building Challenge No. 2
- Ask a friend to print out daily stock charts from great and awful market times (like the Great Recession).
- Ask that friend to cover up everything except the first hour of trading with a blank sheet of paper.
- Then note when you would buy and when you would sell as you gradually uncover the day’s chart.
Do that many times over with other charts. Did you make money? Do that many times, again over different market periods.
If You STILL Want To Try Day Trading
Once you’re confident enough to try investing real money:
- Only invest a small amount into any one trade.
- Don’t put much of your funds into one strategy that might cover many stocks acting the same way. That avoids being too exposed to one factor, like technology or cheap stocks outperforming.
- Keep your trading account separate from your long term investing account.
- Don’t use leverage.
- Once you find a strategy you are comfortable with, be prepared to stick with it. Consistency will help you stay focused.
- And lastly, compare your net results (after deducting expenses) to an industry benchmark.
Once you look hard enough at day trading, you’ll find it has much in common with the Gold Rush of 1849: people made more money selling supplies to the prospectors than the prospectors made sifting for gold.
There will always be risks associated with investing. The surest path to investing success remains saving money, investing for the long term, staying in the market and staying patient.
Contributor Sam Levine holds Chartered Financial Analyst® and Chartered Market Technician® designations and has written on finance topics since 2003. He is an adjunct professor of finance at Wayne State University in Michigan.