In 2015, the investing platform Robinhood launched with (at the time) an astonishing promise of no trade fees or account minimums. And while many scoffed at Robinhood’s business model, the app became wildly popular and forced most of the other major brokers to also offer commission-free trades.
Overall, these industry changes have been a net positive for investors. But free trades and low minimum balance requirements have also caused more retail investors to dip their toes into the trading world. Many of these novice traders (often young) have even gotten involved in the day trading game, lured by its promise of quick profits.
But is this a good idea? Is it really possible for non-professionals to make extra money with day trading? And, if so, what are the risks that also need to be considered? Heres what you need to know about day trading.
What is Day Trading?
Day trading is the act of buying and selling stock market securities within the same trading day. Oftentimes, day traders will actually buy and sell multiple times per day, sometimes only staying in a particular position for a matter of minutes.
Day trading stands in stark contrast to investing, which typically involves a long-term buy-and-hold approach. Rather than searching for financial products with long-term growth potential, day traders look for more volatile securities that are more likely to experience wide intraday price swings. In fact, day traders won’t even hold any positions overnight.
Anyone can make a day trade every once in a while. However, if you make four or more day trades within five business days, your broker will designate you as a Pattern Day Trader (PDT). And, according to the rules set by the Financial Industry Regulatory Authority (FINRA), PDT traders must have at least $25,000 in their accounts.
If you’ve been identified as a PDT trader and your account balance falls below $25,000, you won’t be allowed to make any more day trades until this threshold has once again been reached. To avoid the PDT rule, you’ll need to restrict your trading activity to no more than three day trades every five days.
What Are The Risks of Day Trading?
Day trading is a legal, federally regulated activity and it is not unethical. And it’s true that some day traders earn impressive incomes. However, there are serious risks you’ll want to be aware of before deciding to give it a shot. Here are four reasons that day trading can be a perilous way to make extra money.
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Day Traders Can Suffer Huge Losses In A Matter Of Minutes
Most day traders use tools like stock scanners and candlestick charts to pick stocks or funds that are likely to move up or down quickly. If they think the price is going to rise, they’ll take a long position (purchase shares). But if they think the price will move lower, they may decide to short-sell the security.
If things go according to plan, the trade will result in a profit. But if the trader guesses wrong about the direction the stock will move, losses can pile up quickly. Volatile stocks can move over 5% per day, so you could easily lose 2% to 3% or more in a matter of minutes on just one bad trade. And your daily loss totals could look much worse if you happen to make several bad trades in a row.
What’s more, the SEC says that most brand new day traders struggle and experience severe losses within the first few months. For these reasons, it’s a good idea to try your hand at day trading for a few weeks or months with paper money, before risking your real hard-earned dollars and cents.
Related: How to Create a Trading Plan
Day Traders May Feel Tempted to Stay in Bad Positions to Avoid Losses
Losing 3% on one trade can feel like the end of the world, but it’s honestly not. Long-term investors often suffer daily portfolio losses in that range as well. As long as traders move quickly to close losing positions, each individual trade can cause minimal damage.
This is why most day trading guides stress the importance of having a trade plan in mind before you ever enter a position. For example, you might decide ahead of time that you’ll lock in profits if the stock you’re buying rises $0.80 and will cut your losses if it drops $0.20 (a 1:4 loss/profit ratio).
However, day traders can suffer huge losses when they aren’t disciplined enough to stick with their plan. Imagine that using the trade plan described above, the security you bought drops $0.20 within a minute of purchasing your shares. Instead of selling your shares, you decide to wait a little longer because you have a feeling that the price will rebound.
This kind of emotional speculation can be disastrous for a day trader. Within minutes, a $0.20 drop can turn into an $0.80 drop. Some day traders will also try to average down, by buying more shares as the price continues to fall. Averaging down is a terrible idea for day traders because there’s simply no guarantee that the stock will experience an intraday price rebound.
If you do decide to try your hand as a day trader, religiously following your trade plan (even when that means taking a small loss on a position) will be critical to your success over the long haul.
Day Traders Can Actually Lose More Money Than They Deposited
If you’re identified as a Pattern Day Trader, not only will you need to meet the $25,000 minimum account balance requirement, but you’ll also need to use a margin account. Unlike cash accounts, margin account holders can borrow money from their broker to buy securities.
While brokers do charge interest on margin funds, the interest charges will be minimal if the funds are returned quickly. Plus, if the stocks or funds purchased with margin funds rise in price, the profits will usually outweigh the interest cost.
But the danger of using margin with day trading is that you can spend more money than you actually have in your account. And if one or more of your trades go against you, your account balance could fall below the maintenance margin level resulting in a margin call.
If your broker does make a margin call on your account, you’ll be required to deposit cash to repay your margin debts and bring your account back up to its maintenance margin level. According to the SEC, many day traders rely heavily on margin to increase their profits. But this can also amplify losses and cause traders to quickly get in over their heads.
Day Traders May Pay More In Taxes and Fees
When an asset is held for less than a year, it is subject to the short-term capital gains tax. However, if an asset is held for at least a year or longer, it is taxed instead as a long-term capital gain.
The short-term capital gains tax is taxed the same as regular income. So, depending on your tax bracket, you could pay 10% to 37% on your profits from short-term investments. Long-term capital gains, on the other hand, are generally more favorable. The current long-term capital gain tax rates are 0%, 15%, or 20%, depending on your income level.
Since day traders are certainly not keeping their investments for a year, all of their profits will be subject to the short-term capital gains tax. And, with few exceptions, this will result in higher annual tax costs for day traders than long-term investors.
In addition to higher taxes, day traders may also incur higher broker costs. Even with brokers that don’t charge trade commissions, day traders may need to pay for their premium trading platform or other products like Level 2 quotes, stock scanners, and charting tools.
Related: Best Tax Software for Day Traders
What Are the Potential Rewards of Day Trading?
The biggest, and most obvious, potential advantage of day trading is that you can enjoy much larger daily returns and faster compound interest when compared to long-term investing.
For example, let’s assume that a day trader makes 8 trades per day, risking 1% of their capital on every trade. Well further assume that winning trades net them a profit of 2% and losing trades result in a loss of 1%. If the trader wins 50% of their trades, they’d end the day with a net profit of 4%.
Even without taking compound interest into account, this rate of growth would cause an account to double in size in just 25 trading days. Even with a return of 1% per day, the trader would net an uncompounded annual return of over 200%. By comparison, the average annual return for the S&P 500 is about 10%.
Another benefit of day trading is that it’s possible to make money during stagnant markets or even during market downturns. Even if the market as a whole is moving downward, savvy day traders can identify the day’s hot stocks that have profit potential.
How Can Day Traders Reduce Their Risks?
Is it possible to minimize some of the associated risks of day trading while still taking advantage of the potential rewards? It turns out that the answer is yes. Here are three helpful strategies to follow.
Take Small Position Sizes
If you’re going to participate in day trading, it’s critical that you keep each individual trade’s position size small when compared to your entire account balance. Many experts recommend that you never put more than 1% of your capital at risk on a single trade.
To put this in perspective, if you have a $30,000 account, you’d want to risk no more than $300 per trade. This might sound too conservative, but it’s ultimately for your own protection. Even if you were to suffer a 50% loss on one trade, it would only affect your overall portfolio by 0.50%.
By staying committed to only taking small position sizes, you’ll be able to avoid the devastating losses that plague many day traders. As you gain experience, you may consider increasing your maximum position size to 2% or 3% of your total capital. But beginners will want to stick with the safer 1% guideline.
Set A Stop-Loss For Every Trade
Earlier we discussed how tempting it can be for traders to stay too long in losing trades. But stop-loss orders can take the emotion out of the picture when it comes to closing out bad trades.
A stop-loss order is a type of trade that will only execute after an asset falls below a certain price. Traders should set their stop-loss at the price that equals the amount they’re willing to lose.
For example, let’s say you buy XYZ stock for $100 per share and the maximum that you’re willing to lose on the trade is 4%. In that case, you’d want to set your stop-loss at $96. If the stock ever drops to the $96 mark, the stop-loss order will execute, selling your shares at the market price.
To succeed at day trading, you’ll want to set your stop-loss order as soon as you enter a position. This will automatically limit your losses on every trade regardless of your feelings in the heat of the moment.
Avoid Excessive Margin Trading or Short Selling
By using margin, traders can actually double their purchasing power per trade. In other words, to buy 100 shares of QRS company at $100 per share ($10,000 total cost), you could use $5,000 of your own funds and $5,000 of borrowed (marginal) funds.
But this 50% restriction is per security. In total, traders with margin accounts can actually increase their buying power by up to four times. So a margin account with $25,000 of available cash (over the $25,000 maintenance margin requirement) actually has $100,000 of buying power.
But it can be incredibly dangerous to use all or even most of that marginal buying power. To see how margin is a double-edged sword, let’s return to the example from above. If QRS rises by $10 to $110 per share, your 100 shares will be worth $11,000.
That’s a $1,000 profit and double the profit you’d have enjoyed if you had only purchased 50 shares for $5,000. But what if QRS instead dropped by $10 to $90 per share. In that case, you would have lost $1,000 on only $5,000 of actual invested cash. That translates to a loss of 20%.
To avoid huge losses with day trading, aim to only trade with money that you actually have in your account and use margin sparingly. Yes, that will mean smaller profits. But it will also mean smaller losses which is crucial to long-term performance (and avoiding margin calls).
Short selling is another riskier investment strategy that beginners should avoid. In theory, there is no limit to the amount of money that you can lose when short selling a stock. So until you’ve gained trading experience, stick with buying stocks (going long) using cash on hand.
How Much Time Do Day Traders Need To Dedicate Per Day?
To consider how much time you need to dedicate as a trader, it’s important to understand the difference between a day trade and swing trade. While day trades typically only take a few minutes or hours to play out, a swing trade can take days or weeks.
Unlike long-term investors, swing traders still are looking for assets to move up in a relatively short timespan. But since they regularly hold investments overnight (or for several nights), it’s not imperative that they actively trade each day.
Most day traders will need to dedicate at least three to four hours per day. Typically, this would involve about one hour of research before the market opens and two to three hours of trading.
Since swing traders make trades less frequently, they also can get by with spending less time tracking and updating orders. In fact, many swing traders will find that they can effectively manage their active trades with a time commitment of just a few hours per week.
Related: Best Tax Software for Investors
Who Is Day Trading a Good Fit For?
Day trading would work best for someone who can dedicate three to four hours per day researching and trading stocks. Also, those hours will need to be at the beginning of the trading day when the market is most active.
For example, if you live on the East Coast and you typically work a noon-to-8-pm shift, you may be able to also dedicate time each morning to day trading. Or, if you live on the West Coast, you could trade from 6:30 am to 9:30 am and still have the majority of the day free to work a traditional day job.
However, if you only have a few hours per week to dedicate to trading, you may want to pursue a swing trading strategy instead.
You also need to ask yourself if you have the right personality for day trading or swing trading. In either case, if you find that one bad trade adds a ton of extra stress and anxiety to your life, you may want to forgo trading altogether and just stick with long-term investing.
Best Tools To Get Started With Day Trading
In addition to a computer (preferably with a large amount of screen real estate) and internet access, there are a few more tools that can make a day trader’s life easier. Thankfully, with the best day trading brokers, most of these tools will come baked in with the platform.
First, you may want to ask your broker for Level 2 quotes to give you a better sense of a stock’s price action. Also, you’ll want to look for a broker whose trading platform offers advanced charting and scanning tools.
If you can find a broker that offers paper trading (trading simulators), this is a big bonus. This gives you the option of practicing inside the simulator until you feel confident enough to trade with real money. Finally, since you’ll likely be conducting multiple trades per day, it’s crucial that you choose one of the following discount brokers that offer commission-free trading.
Best Brokers for Day Trading
A quick Google search will reveal that a high percentage of day traders swear by TD Ameritrade. And that’s thanks, in large part, to its powerful trading platform called thinkorswim.
You’ll be hard-pressed to find a platform with more elite trading tools. Thinkorswim boasts 400+ technical studies and 20 drawings in addition to loads of economic data, custom alerts, and 24/5 trading. Its paper-trading platform is also robust.
TD Ameritrade charges $0 commissions on stocks, ETFS, and options and provides Level 2 data for free as well. It also says that 98% of market orders that execute on thinkorswim receive a better price than the National Best Bid and Offer (NBBO) when the order is routed.
E*TRADE is another discount broker that offers a surprisingly well-rounded trading platform. Dubbed Power E*TRADE, it includes 100+ studies, 30+ drawing tools, and a large variety of chart types. Its also available on mobile for both Android and iOS.
In addition to the advanced trading tools built-in to Power [wp_shortcode_121], customers pay $0 commissions on stocks, options, and ETFs. And new customers can earn a bonus of up to $2,500 after opening and funding their account.
This is the company that started it all. Day traders began flocking to Robinhood years ago because it was one of the only brokers that offered free trades (on stocks, ETFS, and options). Although free trades aren’t really unusual anymore, Robinhood is still incredibly popular with traders.
At launch, Robinhood was a mobile-only platform, meaning it was built from the ground with phone ease-of-use being a top priority. But while Robinhoods app is certainly well-designed, its simplicity could also be considered a disadvantage.
For serious day traders who rely heavily on technical analysis, Robinhoods trading tools and research data are somewhat limited compared to platforms like thinkorswim or Power E*TRADE. However, it does offer fractional share investing (for as little as $1) and your uninvested cash earns 0.30% APY.
Ally Invest has really come on strong in the past few years in its quest to build an attractive platform for high-frequency traders.
Like most of its competitors, it offers free trades on U.S. stocks, ETFs, and options. But it has also developed a powerful trading platform chocked full of tools like streaming charts, watchlists, profit/loss graphs, ETF screeners, and more.
There is no account minimum to get started on Ally Invests Self-Directed Trading platform. And new customers can earn a cash bonus of up to $3,500 after opening and funding their account.
You Invest by JP Morgan
J.P. Morgans You Invest platform has two main branches. First, it offers You Invest Portfolios, which are smart portfolios intended to attract long-term investors. You Invest Portfolios have a minimum balance requirement of $500 and an advisory fee of 0.35%.
Traders, however, may be more intrigued by the other arm of the You Invest platform, called You Invest Trade. You Invest Trade offers free trades on stocks, ETFs, and options along with $0 minimum balances. It also offers a strong selection of research tools and data, including its proprietary Portfolio Builder tool.
Related: Best Stock Trading Apps
The Bottom Line
Day trading isn’t for everyone. It can be a stressful way to earn income and requires a significant amount of time, research, and poise. Many people with busy lives and full-time jobs may feel that long-term investing is a better fit for their schedule and personality.
But for those who have the time and temperament, day trading can be a legitimate way to make extra money online. If you do decide to give day trading a try, be sure to limit your risk by taking small position sizes, using stop-loss orders, and trading with cash on hand whenever possible.