The allure of day-trading is undeniable: Be your own boss, create your own schedule, work from home and make a fortune. That is the dream of thousands of day-traders. A few will experience much of the success they seek while most will lose money and ultimately surrender to defeat. Day-trading is a high-stakes game and those who are unprepared for the challenge either financially, mentally or educationally will likely suffer.
So, before quitting the day job, a potential day-trader should seriously evaluate whether he is suitable for the task at hand.
First, he must carefully examine his financial situation. Does he have enough available capital to play the game? Most day-traders initially lose money. It takes time to master a strategy and effectively execute it. There may be months of losses before any profits are realized. So, in the simplest of terms, you need enough workable capital to cover both trading expenses and losses. Trading is not cheap.
Quality tools, such as an electronic trading platform, a real-time data feed provider, a charting and analytical program, and training and education, are required. To take the day-trading journey, you need to be able to afford the trip.
Second, day traders need to possess a certain disposition. Traders must take risk. Some people simply cannot handle the emotional roller coaster that day- trading brings with it. For some, the thought of losing money is so frightening that rational decisions under the gun are impossible. Others may have the fortitude, but they are too greedy. They take foolish risks that result in financial ruin. Traders must have the emotional balance needed to moderate fear and greed.
Arrogance is another dagger to the heart of day-trading potential. All traders make mistakes and all winning strategies produce losing trades. Individuals who cannot accept their mistakes are doomed. They will hold losing trades too long and get fleeced. Similarly, while some humility is a good thing, too much breeds a tendency to abandon winning trades early, limiting profits. Good traders believe in themselves and their strategy.
Finally, if the financial resources and the psychological makeup are in place, a day-trader must understand the markets. He must be willing to invest the time needed to gain knowledge of the markets. Only then is the day trader ready to move to the next step: Deciding what to trade.
FIRST THINGS FIRST
Day traders need a product that has liquidity and volatility. Liquidity is essential because it is necessary to enter and exit the market quickly with minimal slippage. Volatility is the source of all profits — the stock, futures or option must move up or down in price for money to be made. An array of financial products lend themselves to day-trading.
The area probably most familiar to the majority of potential day-traders is stocks. A good rule of thumb is to select a blue-chip stock with an average true range of at least $1.00 and trading volume of at least two million shares per day. Such liquidity allows the trader to enter and exit positions when he chooses. Several futures contracts also are good choices for day trading (see “Which would you prefer?” below).
Day traders generally rely more on technical analysis than fundamentals. They look at numbers, charts and statistics. They identify pivots and use them for buying or selling. Taking this approach, it is not necessary to pour over corporate reports.
For equity traders, it is possible to day-trade with a regular investment account, and some do. However, a stock margin account offers more advantages — benefits that futures traders know well. It allows leverage for short-term plays. Day-traders may leverage 75% of the trade (more for intraday trades). That means with $50,000 in his account, the day trader has the ability to trade $200,000 in stocks.
Leverage is, of course, a double-edged sword. Losses may mount quickly. A frequent, and major, mistake for day traders is to use leverage too freely, particularly when limited to one position.
For the best leverage, stock traders need to be classified as pattern day-traders. A pattern day-trader makes at least four intraday trades in a security within a five-day period. Such activity must also make up at least 6% of the trader’s overall trading activity, and the day-trader must maintain a minimum balance of $25,000 in his account. (For more information about the Pattern day-trading Rule see SEC and NASD Rule 2520.)
If trading stocks, available hours are limited. For example, to trade a stock listed on the New York Stock Exchange or the Nasdaq, the exchange must be open. If there is a big world event that occurs at night, such as a terrorist attack or merger/acquisition activity, the trader is locked out of the stock market until the exchange opens the following day.
A discount broker with low commissions is critical. Otherwise, this basic cost of trading will eat away profits. As a rule, commissions per trade can run around $7 to $15. It is worth it to shop around for the best deal.
THE DERIVATIVE ALTERNATIVE
Of course, stocks aren’t the only vehicle available for day-trading. They may not even be the best choice.
Options also offer day-trading potential. Both cash accounts and margin accounts are available for options. Each option contract effectively gives the buyer control over 100 shares of stock. Options offer other benefits that are beyond the scope of this article, but suffice it to say that they have flexibility in terms of position construction and hedging that are unique.
Futures are often great day-trading opportunities. Futures contracts offer the ability to indirectly trade stocks by trading equity index futures such as the S&P 500, the Dow Jones Industrial Average, the Nasdaq 100 or even non-U.S. indexes, such as the German Dax. Many of these markets offer both full-sized and so-called “mini” contracts. For example, the big S&P 500 contract is valued at $250 per point, but the E-mini S&P 500 has a value of only $50 per point. Not only does this mean this contract can be traded with less equity in an account, but there is less dollar-for-dollar risk in a smaller position.
Another benefit of futures is volatility. The average true range of these products constantly changes, but a typical daily true range for the Dow is about 100 points. Even though the mini-Dow is valued at only $5 per point, that range still allows quite a bit of money to be made on an intraday basis.
All futures contracts require a margin account and the margin for trading futures is relatively low, especially when compared to the margin required for trading stocks. For intraday transactions, some brokerage firms require as little as $2,500 to be held in the account per E-mini contract. If the S&P 500 Index is trading at 1500, that means the value of one contract is approximately worth $75,000. Under such circumstances, a small percentage move on a contract value basis can result in considerable profits on that $2,500 investment. That equates to quite a bit of exposure for your money.
But, again, with considerable leverage comes greater risk. High leverage means margin calls are more likely. Losses can quickly mount if positions are not well-funded and the noise of the market frequently causes positions to be abandoned before they have a chance to work as intended.
One of the biggest advantages of futures is the virtual 24-hour accessibility. This is the ultimate definition of setting your own hours. If you want to trade at 3 a.m., go ahead. The German Dax is available and active at that time. In addition, if there’s a major market-moving event, you have the ability to react, regardless of the hour.
Many domestic futures contracts are available to trade nearly 24 hours. The E-mini S&P 500 and the Nasdaq futures can be traded electronically from 3:30 p.m. (CST) until 3:15 p.m. the following day. Then, they rest for 15 minutes before starting it up all over again.
Futures also offer a unique tax structure. Profits made from trading futures are taxed according to the 60/40 Rule. That is, 60% of profits are taxed as long-term capital gains. Even if the position is held for less than a minute. The remaining 40% of earnings are taxed at regular income.
A benefit of futures that really helps the bottom line is that through the last few years, the cost of trading futures has fallen dramatically. A short time ago, a commission of $25 or more was typical for one trade. Today, there are mainstream brokers who charge as little as $4 or $5 per contract. When you consider how much exposure you get for just one futures contract, that’s an even better deal.
Futures also represent markets that transcend the familiar financials that most potential day-traders know.
There are futures based on currency markets, which also can be traded directly through a forex broker. Like equity index futures, currencies can be traded virtually 24 hours per day and offer the same leverage benefits.
Commodities, of course, are the traditional arena for futures traders. Futures are listed on grains, cattle and pork, energies, and both industrial and precious metals. Different commodities have different trading hours. It’s important to look into the detailed contract specifications for any futures being considered for day-trading. Depending on the trader’s logistical requirements, some contracts simply might not work.
Next month, this series will dive into the real meat of day-trading: identifying entries and exits. We will cover both the logic and details of an approach that has reliably served day-traders across markets for years.
Tom Busby is a 30-year professional trader and Founder of DTI, a trading school in Mobile, Ala. Busby is a member of the CME and CBOT and has been seen on Bloomberg, CNBC and BNN. For more on Busby go to www.dtitrader.com.