Define Day Trader
Strictly speaking, a day trader is someone who buys and sells the same security or securities on the same day. A day trader may trade a variety of instruments: stocks, exchange-traded funds (ETFs), options or futures. The term “day trader” is also loosely applied to anyone who is not a long-term investor, including swing or position traders and scalpers.
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Types of Day Traders
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A day trader can work for an institution (bank, large brokerage, hedge fund), trading the firm’s capital, or he can be an individual who trades his own capital from home.
Trading Instruments
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Day traders can trade stocks as well as ETFs and options and futures. The key criterion is volatility (wide daily moves) and liquidity (the ability to buy and sell large quantities of a security fast at a minimal cost). Different stocks may attract day traders at different times for different reasons. This can be seen when a seemingly “sleepy” stock all of a sudden becomes very active, trading at a very high volume and having frequent wide fluctuations in price.
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Opportunities
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On average, a stock can fluctuate up to 5 percent daily. If you can capture just 1 or 2 percent, that’s 260 to 520 percent annualized. Of course, this is the theory, which does not take into account frequent losses or a trader’s skill level, but it illustrates the potential.
Risks
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Short-term fluctuations are much less predictable than long-term trends. What can go up 1 percent can just as easily go down 1 percent in a matter of hours or even minutes.
A day trader can handle only a limited number of positions or trades at a time. Since she has to settle for small frequent gains, she must concentrate her capital in a few large positions, moving in and out constantly, to produce meaningful returns in dollar terms. Trading a few large positions is risky if any one of them moves against you, compared with holding a diversified portfolio of stocks, bonds and mutual funds.
Technical glitches—the computer freezing, the Internet connection or broker platform being down or even a power outage—can cause execution delays sufficient to turn a small profit into a large loss in minutes.
Advantages
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Statistically, the probabilities of finding a few big winners (and holding them all the way to the top) are much slimmer than trading on short-term fluctuations. Relatively few stocks become “ten-baggers” (go up tenfold), while all stocks fluctuate daily. In the end, it does not matter whether you double your money in 100 1 percent gains or in one 100 percent run. A day trader would argue that the former is more realistic and doable.
Day traders limit their downside risk by closing out all positions at the end of each day. Many unpleasant surprises happen outside the market hours. If some bad news comes out after the market closes, a stock can gap down (open at a price much lower than the previous close) the following morning, causing instant losses for investors but not affecting day traders who are in cash.
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References
- Photo Credit computer image by Hao Wang from Fotolia.com
