From the December 01, 2006 issue of Futures Magazine • Subscribe!

Day Trading: then and now

People used to view day trading as simply another way to gamble away investment dollars. Today, however, many of those same critics are becoming intrigued with this approach as another way to diversify their otherwise tepid portfolios. Much of this increase in acceptance has been due to the logistical and market-access hurdles that have been eliminated by online trading firms and electronic markets.

Of course day trading has existed on-the-floor for generations. Even off-the-floor day trading has been employed by traders for years. However, the day trading landscape of today, defined by the markets and the tools traders use to access them, is much different than that of either of those earlier approaches.

While misconceptions about day trading still exist, this new style is adapting as its logistics continue to evolve. New and long-time traders who have yet to explore this approach in depth can benefit from an understanding of day trading’s history, the current technology, modern tools and new markets that are available to them.

THE EARLY DAYS

During the late 1990s, the stock market was making a significant rally with the explosion in popularity of technology stocks. This boom created a wave of trading hysteria that brought day trading to the forefront of the American financial scene. What had long been the domain of institutional and professional traders working at the exchanges had become accessible to anyone with a computer, a trading account and the moxie.

Many starry-eyed traders quit their regular jobs with the intention of making big, easy money day trading the stock market. Books, seminars and courses in day trading were popping up everywhere, promising would-be day traders an easy path to making their first and second million.

Because the markets were making such large gains, trend-following was key. Finding a volatile Nasdaq stock, leveraging with a significant amount of margin, and jumping on for the ride often proved lucrative. Many boasted trading was as easy as printing money.

Trading arcades grew in popularity and offered well-funded day traders a gathering place to learn, share ideas and trade. These trading arcades typically provided traders with fast computers, access to analytical software and direct-access trading that were prohibitively expensive to individual traders at the time.

Like the California gold rush of 1849, the stock market craze was shortlived, and by 2001 many aspiring day traders had lost huge amounts of money during the subsequent fall. While retail investing and trading continued to shape the stock market, increased market competition and corporate scandals created an atmosphere that required much more caution.

MicroStrategy (MSTR), shown in “How fast we fall” (below), tumbled from a high of $3,330 per share on March 10, 2000, to $630 just seven trading days later after reporting its 1999 revenues were 25% less than declared. It continued on to drop in value to under $10 during the next two and a half years, becoming a poster child for the dot-bomb era.

Following the correction, the Securities and Exchange Commission introduced new regulations limiting how stocks could be traded and imposed account restrictions on day traders. A critical change was the designation of a pattern day trader (PDT), referring to any individual making four or more day trades within a consecutive five-day period, with the number of day trades accounting for more than 6% of the total trades during that period.

The new designation required pattern day traders to maintain a minimum of $25,000 account equity at all times and introduced more restrictive margin requirements. The PDT designation was put into place to limit the risk on the brokerages, and to ensure that any substantial trading losses could be offset by the trader’s own account.

MODERN MARKETS

While day trading individual stocks still offers opportunities, other equity-oriented instruments may be better suited for modern day trading. Although most of these instruments are based on the stock indexes, they may offer fewer restrictions, have greater transparency and typically require significantly less research and scanning than individual stocks.

Exchange-traded funds (ETF), have become a favorite trading instrument among modern day traders. Originally introduced by the American Stock Exchange in 1993, the most popular ETFs follow the major U.S. stock indexes, with the most popular being the Nasdaq 100 Trust Shares (QQQQ) and the Standard & Poor’s Depository Receipts (SPY).

A bonus in trading ETFs is that while individual stocks are subject to the well-known rule that only allows short sales following an uptick in the stock’s price, ETFs, like futures, do not have this restriction. Traders can go short just as easily as they can go long. ETFs can present good opportunities for intraday trading, and, due to their popularity, most online brokers now offer access to them.

The futures market also has become another hot spot for modern day traders because it does not have any pattern day trading restrictions. Futures also allow for greater margin and can be sold short with no restrictions. The trading instruments of choice for many day traders are the E-mini futures contracts, introduced by the Chicago Mercantile Exchange in 1997. The E-mini index futures are smaller versions of the long-established full-sized stock index futures and trade around-the-clock on all-electronic networks. These extremely liquid trading instruments are much more affordable to smaller investors than the full-sized stock index futures contracts. These markets are known for being fast and transparent.

DAY TRADING TECH

The technological advances through the past decade have considerably enhanced the speed, quality and accuracy of the data and trade executions available to traders. The typical day trader now uses a top-notch computer setup, multiple monitors and a high-speed Internet connection. Additionally, brokers now cater to different styles of day trading by offering specific services, data and research.

High-end charting and order entry platforms have become standard equipment, granting day traders tick-by-tick access to a variety of markets (see “Operation overload?” below).

These platforms offer customization with indicators, studies and strategies that can be programmed by the user or purchased commercially. These let day traders research and develop techniques that can pinpoint specific conditions in a market.

Perhaps more important to advances in day trading have been developments in order entry and automated trading services. Direct-access trading, which provides direct access to the exchange markets, has become the standard for today’s day traders. Brokers that specialize in direct-access trading offer extremely fast order executions, a variety of advanced order types and discounted commissions.

Once available only to institutions, several direct-access trading platforms offer the ability to automate part or all of a trading strategy. Some of these platforms allow for the automated management of existing positions, while others offer fully mechanical trading, including trade entries and exits.

While many associate day trading with being locked in front of a computer all day, alternatives are available that can greatly reduce the stress and the amount of screen time that have traditionally typified day traders.

STRATEGIES TODAY

Day trading has changed considerably throughout the years as markets and investor habits continue to evolve. Many day trading systems created a few years ago have already become obsolete. Day trading remains a dynamic method of investing and it requires constant attention to the current conditions.

While trend-following was a popular day trading method during the late 1990s, it is no longer viable for most traders. Many of the large moves, and resulting rock-star trades typical to the late 1990s, have been replaced by smaller moves and more pedestrian trades. With the volatility crunch in many markets in the past few years, many traders are forced to capture smaller moves (see “Shrinking opportunity”).

As trading instruments change through time, so must systems. Traders are well advised to expect changes in the market environment. These include changes in the fundamentals that affect the market prices and volatility.

A common method used by modern day traders is trading within an intraday channel using support and resistance. Instead of focusing on longer-term support and resistance values, such as those found on daily or weekly price charts, many traders are able to capitalize on the high probability of fluctuations between prior turning points (or swings) in intraday price. Although these fluctuations may be relatively small compared to the large moves of the past, there is still plenty of room for savvy day traders to profit. One such example can be seen in “Short-term extremes” (above).

To help spot these important intraday support-and-resistance levels, traders can draw a series of horizontal lines marking swing highs and lows on a price chart. Once spotted, these trendlines may be used to not only enter a trade, but to set precise profit targets and stop-loss levels based on that day’s trading.

Another technique frequently employed by day traders is countertrend trading. This approach looks for weakness in a trend and attempts to take an opposing position. Countertrend traders attempt to capitalize on the often-dynamic directional changes in choppy markets.

One method of spotting a countertrend move involves the use of strong intraday trendlines to spot a bearish or bullish market. These strong trendlines can be defined by three or more price swings forming the basis for the trendline. Once price breaks this trendline, it may indicate a change of trend and offer a lucrative trading opportunity.

Because it is important that countertrend methodologies determine a real move and not just a pullback, traders may elect to use a variety of methods or filters. These may include candlestick patterns as well as popular oscillators such as stochastics or the relative strength index. Along with a trendline break, “Signs to trade by,” above, shows a bullish engulfing candlestick pattern and a move outside of the oversold zone of the 20-period stochastic.

NEW DAWN

Many of us learned about day trading during the dynamic tech stock bubble of the mid-1990s and its subsequent crash. It was easy to assume that the day trading gold rush would last forever. Instead, corporate scandals hit the headlines, investors turned towards caution and the markets changed.

Day trading, which once drummed up visions of high-strung, bleary-eyed gamblers risking it all, has evolved into a style of trading that has gained attention from private investors looking for dynamic portfolio diversification, as well as professional money managers. Day trading, like any other style of trading, requires research, responsible risk management and an innovative and flexible view of the markets.

Jean Folger is a system researcher and analyst for PowerZone Trading, a company that provides educational services and custom programming for traders. She can be reached at jean@powerzonetrading.com.

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