Day trading
Encyclopedia
Day trading refers to the practice of buying and selling financial instruments
within the same trading day such that all positions are usually closed before the market close for the trading day. Traders that participate in day trading are called active traders or day trader
s.
Not widely known, the correct definition of an "intra-day" means the move as measured from the previous close and not just relative to another price traded on the same day.
Some of the more commonly day-traded financial instruments are stock
s, stock options, currencies
, and a host of futures contract
s such as equity
index futures, interest rate
futures, and commodity futures.
Day trading used to be activity exclusive to financial firms and professional investors and speculators. Indeed, many day trader
s are bank
or investment firm employees working as specialists in equity investment and fund management. However, with the advent of electronic trading and margin trading, day trading has become increasingly popular among at-home traders
.
Some day traders focus on very short-term trading within the trading day, in which a trade may last just a few minutes. Day traders may buy and sell many times in a trading day and may receive trading fee discounts from their broker for this trading volume.
Some day traders focus only on price momentum, others on technical patterns, and still others on an unlimited number of strategies they feel can be profitable.
Most day traders exit positions before the market closes to avoid unmanageable risks—negative price gaps (differences between the previous day's close and the next day's open bull price) at the open—overnight price movements against the position held. Other traders believe they should let the profits run, so it is acceptable to stay with a position after the market closes.
Day traders sometimes borrow money to trade. This is called margin trading. Since margin interests are typically only charged on overnight balances, the trader pays no fees for the margin benefit, though still running the risk of a Margin call
. The margin interest rate is usually based on the Broker's call
.
and the rapid returns that are possible, day trading can be either extremely profitable or extremely unprofitable, and high-risk profile traders can generate either huge percentage returns or huge percentage losses.
Because of the high profits (and losses) that day trading makes possible, these traders are sometimes portrayed as "bandits" or "gamblers" by other investors. Some individuals, however, make a consistent living from day trading.
Nevertheless day trading can be very risky, especially if any of the following is present while trading:
The common use of buying on margin (using borrowed funds) amplifies gains and losses, such that substantial losses or gains can occur in a very short period of time. In addition, brokers usually allow bigger margins
for day traders. Where overnight margins required to hold a stock position are normally 50% of the stock's value, many brokers allow pattern day trader accounts to use levels as low as 25% for intraday purchases. This means a day trader with the legal minimum $25,000 in his or her account can buy $100,000 (4x leverage) worth of stock during the day, as long as half of those positions are exited before the market close. Because of the high risk of margin use, and of other day trading practices, a day trader will often have to exit a losing position very quickly, in order to prevent a greater, unacceptable loss, or even a disastrous loss, much larger than his or her original investment, or even larger than his or her total assets.
. A trader would contact a stockbroker, who would relay the order to a specialist on the floor of the NYSE. These specialists would each make markets in only a handful of stocks. The specialist would match the purchaser with another broker's seller; write up physical tickets that, once processed, would effectively transfer the stock; and relay the information back to both brokers. Brokerage commissions were fixed at 1% of the amount of the trade, i.e. to purchase $10,000 worth of stock cost the buyer $100 in commissions. (Meaning that to profit trades had to make over 1.010101...% to make any real gain.)
One of the first steps to make day trading of shares potentially profitable was the change in the commission scheme. In 1975, the United States Securities and Exchange Commission
(SEC) made fixed commission rates illegal, giving rise to discount brokers offering much reduced commission rates.
, for example, stock could be paid for up to 10 working days after it was bought, allowing traders to buy (or sell) shares at the beginning of a settlement period only to sell (or buy) them before the end of the period hoping for a rise in price. This activity was identical to modern day trading, but for the longer duration of the settlement period. But today, to reduce market risk, the settlement period is typically three working days. Reducing the settlement period reduces the likelihood of default
, but was impossible before the advent of electronic ownership transfer.
s (ECNs). These are essentially large proprietary computer networks on which brokers could list a certain amount of securities to sell at a certain price (the asking price or "ask") or offer to buy a certain amount of securities at a certain price (the "bid").
ECNs and exchanges are usually known to traders by a three- or four-letter designators, which identify the ECN or exchange on Level II stock screens. The first of these was Instinet
(or "inet"), which was founded in 1969 as a way for major institutions to bypass the increasingly cumbersome and expensive NYSE, also allowing them to trade during hours when the exchanges were closed. Early ECNs such as Instinet
were very unfriendly to small investors, because they tended to give large institutions better prices than were available to the public. This resulted in a fragmented and sometimes illiquid market.
The next important step in facilitating day trading was the founding in 1971 of NASDAQ
—a virtual stock exchange on which orders were transmitted electronically. Moving from paper share certificates and written share registers to "dematerialized" shares, computerized trading and registration required not only extensive changes to legislation but also the development of the necessary technology: online and real time systems rather than batch; electronic communications rather than the postal service, telex or the physical shipment of computer tapes, and the development of secure cryptographic algorithms.
These developments heralded the appearance of "market maker
s": the NASDAQ equivalent of a NYSE specialist. A market maker has an inventory of stocks to buy and sell, and simultaneously offers to buy and sell the same stock. Obviously, it will offer to sell stock at a higher price than the price at which it offers to buy. This difference is known as the "spread". The market maker is indifferent as to whether the stock goes up or down, it simply tries to constantly buy for less than it sells. A persistent trend in one direction will result in a loss for the market maker, but the strategy is overall positive (otherwise they would exit the business). Today there are about 500 firms who participate as market-makers on ECNs, each generally making a market in four to forty different stocks. Without any legal obligations, market-makers were free to offer smaller spreads on ECN
s than on the NASDAQ
. A small investor might have to pay a $0.25 spread (e.g. he might have to pay $10.50 to buy a share of stock but could only get $10.25 for selling it), while an institution would only pay a $0.05 spread (buying at $10.40 and selling at $10.35).
", or "SOES", which required market makers to buy or sell, immediately, small orders (up to 1000 shares) at the market-makers listed bid or ask. A defect in the system gave rise to arbitrage by a small group of traders known as the "SOES bandits", who made fortunes buying and selling small orders to market makers.
The existing ECNs began to offer their services to small investors. New brokerage firms which specialized in serving online traders who wanted to trade on the ECNs emerged. New ECNs also arose, most importantly Archipelago ("arca") and Island ("isld"). Archipelago eventually became a stock exchange and in 2005 was purchased by the NYSE. (At this time, the NYSE has proposed merging Archipelago with itself, although some resistance has arisen from NYSE members.) Commissions plummeted. To give an extreme example (trading 1000 shares of Google), an online trader in 2005 might have bought $300,000 of stock at a commission of about $10, compared to the $3,000 commission the trader would have paid in 1974. Moreover, the trader was able in 2005 to buy the stock almost instantly and got it at a cheaper price.
ECNs are in constant flux. New ones are formed, while existing ones are bought or merged. As of the end of 2006, the most important ECNs to the individual trader were:
This combination of factors has made day trading in stocks and stock derivatives (such as ETF
s) possible. The low commission rates allow an individual or small firm to make a large number of trades during a single day. The liquidity and small spreads provided by ECNs allow an individual to make near-instantaneous trades and to get favorable pricing. High-volume issues such as Intel or Microsoft generally have a spread of only $0.01, so the price only needs to move a few pennies for the trader to cover his commission costs and show a profit.
The ability for individuals to day trade coincided with the extreme bull market in technological issues from 1997 to early 2000, known as the Dot-com bubble
. From 1997 to 2000, the NASDAQ rose from 1200 to 5000. Many naive investors with little market experience made huge profits buying these stocks in the morning and selling them in the afternoon, at 400% margin
rates.
Adding to the day-trading frenzy were the enormous profits made by the "SOES bandits" who, unlike the new day traders, were highly-experienced professional traders able to exploit the arbitrage
opportunity created by SOES
.
In March, 2000, this bubble burst, and a large number of less-experienced day traders began to lose money as fast, or faster, than they had made during the buying frenzy. The NASDAQ crashed from 5000 back to 1200; many of the less-experienced traders went broke, although obviously it was possible to have made a fortune during that time by shorting
or playing on volatility.
) to trade specifically against irrational behavior from day traders using these approaches.
Some of these approaches require shorting
stocks instead of buying them: the trader borrows stock from his broker and sells the borrowed stock, hoping that the price will fall and he will be able to purchase the shares at a lower price. There are several technical problems with short sales—the broker may not have shares to lend in a specific issue, some short sales can only be made if the stock price or bid has just risen (known as an "uptick"), and the broker can call for the return of its shares at any time. Some of these restrictions (in particular the uptick rule) don't apply to trades of stocks that are actually shares of an exchange-traded fund
(ETF).
The Securities and Exchange Commission removed the uptick requirement for short sales on July 6, 2007.
, a strategy used in all trading time-frames, assumes that financial instruments
which have been rising steadily will continue to rise, and vice versa with falling. The trend follower buys an instrument which has been rising, or short sells
a falling one, in the expectation that the trend will continue.
is a market timing
strategy used in all trading time-frames. It assumes that financial instruments
which have been rising steadily will reverse and start to fall, and vice versa with falling. The contrarian trader buys an instrument which has been falling, or short-sells a rising one, in the expectation that the trend will change.
) at the high. A related approach to range trading is looking for moves outside of an established range, called a breakout
(price moves up) or a breakdown (price moves down), and assume that once the range has been broken prices will continue in that direction for some time.
was originally referred to as spread trading. Scalping is a trading style where small price gaps created by the bid-ask spread are exploited. It normally involves establishing and liquidating a position quickly, usually within minutes or even seconds.
Scalping highly liquid instruments for off-the-floor day traders involves taking quick profits while minimizing risk (loss exposure). It applies technical analysis concepts such as over/under-bought, support and resistance zones as well as trendline, trading channel to enter the market at key points and take quick profits from small moves. The basic idea of scalping is to exploit the inefficiency of the market when volatility increases and the trading range expands.
founded Tradescape and the rebate trading group at Tradescape helped to contribute to a $280 million buyout from online trading giant E*Trade.
who are a form of technical traders that rely on technical analysis but do not rely on conventional indicators to point them in the direction of a trade or not. These traders rely on a combination of price movement, chart patterns, volume, and other raw market data to gauge whether or not they should take a trade. This is seen as a "simplistic" and "minimalist" approach to trading but is not by any means easier than any other trading methodology. It requires a sound background in understanding how markets work and the core principles within a market, but the good thing about this type of methodology is it will work in virtually any market that exists (stocks, foreign exchange, futures, gold, oil, etc.).
, or high-frequency trading
. The increased use of algorithms and quantitative techniques have led to more competition and smaller profits.
and arbitrage
) require relatively sophisticated trading systems and software. This software can cost $45,000 or more. Since the masses have now entered the day trading space, strategies can now be found for as little as $5,000. Many day traders use multiple monitors or even multiple computers to execute their orders. Some use real time filtering software which is programmed to send stock symbols to a screen which meet specific criteria during the day, such as displaying stocks that are turning from positive to negative. Some traders use community based tools including forums, message boards and chat rooms.
. Direct access trading offers substantial improvements in transaction speed and will usually result in better trade execution prices (reducing the costs of trading). Outside the US, day traders will often use CFD or financial spread betting brokers for the same reasons.
for direct-access brokers are calculated based on volume. The more shares traded, the cheaper the commission. The average commission per trade is roughly $5 per round trip (getting in and out of a position). While a retail broker might charge $7 or more per trade regardless of the trade size, a typical direct-access broker may charge anywhere from $0.01 to $0.0002 per share traded (from $10 down to $.20 per 1000 shares), or $0.25 per futures contract. A scalper can cover such costs with even a minimal gain.
As for the calculation method, some use pro-rata to calculate commissions and charges, where each tier of volumes charges different commissions. Other brokers use a flat rate, where all commissions and charges are based on which volume threshold one reaches.
The ask prices are immediate execution (market) prices for quick buyers (ask takers) while bid prices are for quick sellers (bid takers). If a trade is executed at quoted prices, closing the trade immediately without queuing would not cause a loss because the bid price is always less than the ask price at any point in time.
The bid-ask spread is two sides of the same coin. The spread can be viewed as trading bonuses or costs according to different parties and different strategies. On one hand, traders who do NOT wish to queue their order, instead paying the market price, pay the spreads (costs). On the other hand, traders who wish to queue and wait for execution receive the spreads (bonuses). Some day trading strategies attempt to capture the spread as additional, or even the only, profits for successful trades.
is necessary for day traders, rather than using the delayed (by anything from 10 to 60 minutes, per exchange rules) market data that is available for free. A real-time data feed requires paying fees to the respective stock exchanges, usually combined with the broker's charges; these fees are usually very low compared to the other costs of trading. The fees may be waived for promotional purposes or for customers meeting a minimum monthly volume of trades. Even a moderately active day trader can expect to meet these requirements, making the basic data feed essentially "free".
In addition to the raw market data, some traders purchase more advanced data feeds that include historical data and features such as scanning large numbers of stocks in the live market for unusual activity. Complicated analysis and charting software are other popular additions. These types of systems can cost from tens to hundreds of dollars per month to access.
s are used by traders using technical analysis to determine chart patterns. Once a pattern
is recognized in the chart, traders use the information to take a position. Some traders consider this method to be a part of price action trading.
and SEC further restrict the entry by means of "pattern day trader" amendments. Pattern day trader
is a term defined by the SEC to describe any trader
who buys and sells a particular security in the same trading day (day trades), and does this four or more times in any five consecutive business day period. A pattern day trader is subject to special rules, the main rule being that in order to engage in pattern day trading the trader must maintain an equity balance of at least $25,000 in a margin account. It is important to note that this requirement is only for day traders using a margin account.
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
within the same trading day such that all positions are usually closed before the market close for the trading day. Traders that participate in day trading are called active traders or day trader
Day trader
A day trader is a trader who buys and sells financial instruments within the same trading day such that all positions will usually be closed before the market close of the trading day. This trading style is called day trading...
s.
Not widely known, the correct definition of an "intra-day" means the move as measured from the previous close and not just relative to another price traded on the same day.
Some of the more commonly day-traded financial instruments are stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s, stock options, currencies
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
, and a host of futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s such as equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
index futures, interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
futures, and commodity futures.
Day trading used to be activity exclusive to financial firms and professional investors and speculators. Indeed, many day trader
Day trader
A day trader is a trader who buys and sells financial instruments within the same trading day such that all positions will usually be closed before the market close of the trading day. This trading style is called day trading...
s are bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
or investment firm employees working as specialists in equity investment and fund management. However, with the advent of electronic trading and margin trading, day trading has become increasingly popular among at-home traders
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
.
Trade frequency
Although collectively called day trading, there are many styles with specific qualities and risks. Scalping is an intra-day technique that usually has the trader holding a position for a few minutes. Shaving is a method which allows the trader to jump ahead by a tenth of a cent, and a full round trip (a buy and a sell order) is often completed in under one second. Instead of bidding $10.20 per share, the scalper will jump the bid at $10.201, thus becoming the best bid and therefore the first in line to be able to purchase the stock. When the best "Offer" is $10.21, the shaver will again jump first in line and sell a tenth of a cent cheaper at $10.209 for a profit of 0.008 of a dollar. The profits add up when using 10,000 share lots each time and the combined earnings from Rebates (read below) for creating liquidity. A day trader is actively searching for potential trading setups (that is, any stock or other financial instruments that, in the judgment of the day trader, is in a tension state, ready to accelerate in price in either direction, that when traded well has a potential for a substantial profit). The number of trades one can make per day is almost unlimited, as are the profits and losses.Some day traders focus on very short-term trading within the trading day, in which a trade may last just a few minutes. Day traders may buy and sell many times in a trading day and may receive trading fee discounts from their broker for this trading volume.
Some day traders focus only on price momentum, others on technical patterns, and still others on an unlimited number of strategies they feel can be profitable.
Most day traders exit positions before the market closes to avoid unmanageable risks—negative price gaps (differences between the previous day's close and the next day's open bull price) at the open—overnight price movements against the position held. Other traders believe they should let the profits run, so it is acceptable to stay with a position after the market closes.
Day traders sometimes borrow money to trade. This is called margin trading. Since margin interests are typically only charged on overnight balances, the trader pays no fees for the margin benefit, though still running the risk of a Margin call
Margin Call
Margin Call is a 2011 American independent drama film, written and directed by J.C. Chandor. The film has an ensemble cast that includes Kevin Spacey, Demi Moore, Paul Bettany, Jeremy Irons, Zachary Quinto, Stanley Tucci, Simon Baker, and Penn Badgley...
. The margin interest rate is usually based on the Broker's call
Broker's call
Broker's call, also known as the Call loan rate, is the interest rate relative to which margin loans are quoted. Individuals may borrow on margin a part of the funds they use to buy their securities from their broker...
.
Profit and risks
Because of the nature of financial leverageLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
and the rapid returns that are possible, day trading can be either extremely profitable or extremely unprofitable, and high-risk profile traders can generate either huge percentage returns or huge percentage losses.
Because of the high profits (and losses) that day trading makes possible, these traders are sometimes portrayed as "bandits" or "gamblers" by other investors. Some individuals, however, make a consistent living from day trading.
Nevertheless day trading can be very risky, especially if any of the following is present while trading:
- trading a loser's game/system rather than a game that's at least winnable,
- trading with poor discipline (ignoring your own day trading strategy, tactics, rules),
- inadequate risk capital with the accompanying excess stress of having to "survive",
- incompetent money management (i.e. executing trades poorly).
The common use of buying on margin (using borrowed funds) amplifies gains and losses, such that substantial losses or gains can occur in a very short period of time. In addition, brokers usually allow bigger margins
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
for day traders. Where overnight margins required to hold a stock position are normally 50% of the stock's value, many brokers allow pattern day trader accounts to use levels as low as 25% for intraday purchases. This means a day trader with the legal minimum $25,000 in his or her account can buy $100,000 (4x leverage) worth of stock during the day, as long as half of those positions are exited before the market close. Because of the high risk of margin use, and of other day trading practices, a day trader will often have to exit a losing position very quickly, in order to prevent a greater, unacceptable loss, or even a disastrous loss, much larger than his or her original investment, or even larger than his or her total assets.
History
Originally, the most important U.S. stocks were traded on the New York Stock ExchangeNew York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...
. A trader would contact a stockbroker, who would relay the order to a specialist on the floor of the NYSE. These specialists would each make markets in only a handful of stocks. The specialist would match the purchaser with another broker's seller; write up physical tickets that, once processed, would effectively transfer the stock; and relay the information back to both brokers. Brokerage commissions were fixed at 1% of the amount of the trade, i.e. to purchase $10,000 worth of stock cost the buyer $100 in commissions. (Meaning that to profit trades had to make over 1.010101...% to make any real gain.)
One of the first steps to make day trading of shares potentially profitable was the change in the commission scheme. In 1975, the United States Securities and Exchange Commission
United States Securities and Exchange Commission
The U.S. Securities and Exchange Commission is a federal agency which holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation's stock and options exchanges, and other electronic securities markets in the United States...
(SEC) made fixed commission rates illegal, giving rise to discount brokers offering much reduced commission rates.
Financial settlement
Financial settlement periods used to be much longer: Before the early 1990s at the London Stock ExchangeLondon Stock Exchange
The London Stock Exchange is a stock exchange located in the City of London within the United Kingdom. , the Exchange had a market capitalisation of US$3.7495 trillion, making it the fourth-largest stock exchange in the world by this measurement...
, for example, stock could be paid for up to 10 working days after it was bought, allowing traders to buy (or sell) shares at the beginning of a settlement period only to sell (or buy) them before the end of the period hoping for a rise in price. This activity was identical to modern day trading, but for the longer duration of the settlement period. But today, to reduce market risk, the settlement period is typically three working days. Reducing the settlement period reduces the likelihood of default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
, but was impossible before the advent of electronic ownership transfer.
Electronic communication networks
The systems by which stocks are traded have also evolved, the second half of the twentieth century having seen the advent of electronic communication networkElectronic communication network
An electronic communication network is the term used in financial circles for a type of computer system that facilitates trading of financial products outside of stock exchanges. The primary products that are traded on ECNs are stocks and currencies. The first ECN, Instinet, was created in 1969...
s (ECNs). These are essentially large proprietary computer networks on which brokers could list a certain amount of securities to sell at a certain price (the asking price or "ask") or offer to buy a certain amount of securities at a certain price (the "bid").
ECNs and exchanges are usually known to traders by a three- or four-letter designators, which identify the ECN or exchange on Level II stock screens. The first of these was Instinet
Instinet
Instinet is an institutional, agency-only broker. As such, it executes trades for roughly 1,500 “buyside” clients such as asset management firms, hedge funds, insurance companies, mutual funds and pension funds...
(or "inet"), which was founded in 1969 as a way for major institutions to bypass the increasingly cumbersome and expensive NYSE, also allowing them to trade during hours when the exchanges were closed. Early ECNs such as Instinet
Instinet
Instinet is an institutional, agency-only broker. As such, it executes trades for roughly 1,500 “buyside” clients such as asset management firms, hedge funds, insurance companies, mutual funds and pension funds...
were very unfriendly to small investors, because they tended to give large institutions better prices than were available to the public. This resulted in a fragmented and sometimes illiquid market.
The next important step in facilitating day trading was the founding in 1971 of NASDAQ
NASDAQ
The NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations". It is the second-largest stock exchange by market capitalization in the world, after the New York Stock Exchange. As of...
—a virtual stock exchange on which orders were transmitted electronically. Moving from paper share certificates and written share registers to "dematerialized" shares, computerized trading and registration required not only extensive changes to legislation but also the development of the necessary technology: online and real time systems rather than batch; electronic communications rather than the postal service, telex or the physical shipment of computer tapes, and the development of secure cryptographic algorithms.
These developments heralded the appearance of "market maker
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
s": the NASDAQ equivalent of a NYSE specialist. A market maker has an inventory of stocks to buy and sell, and simultaneously offers to buy and sell the same stock. Obviously, it will offer to sell stock at a higher price than the price at which it offers to buy. This difference is known as the "spread". The market maker is indifferent as to whether the stock goes up or down, it simply tries to constantly buy for less than it sells. A persistent trend in one direction will result in a loss for the market maker, but the strategy is overall positive (otherwise they would exit the business). Today there are about 500 firms who participate as market-makers on ECNs, each generally making a market in four to forty different stocks. Without any legal obligations, market-makers were free to offer smaller spreads on ECN
ECN
ECN may refer to:* Eastern Counties Newspapers, a company now known as Archant* Eastman Color Negative, a photographic processing system for motion-picture films* Electrochemical noise, fluctuations of current and potential...
s than on the NASDAQ
NASDAQ
The NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations". It is the second-largest stock exchange by market capitalization in the world, after the New York Stock Exchange. As of...
. A small investor might have to pay a $0.25 spread (e.g. he might have to pay $10.50 to buy a share of stock but could only get $10.25 for selling it), while an institution would only pay a $0.05 spread (buying at $10.40 and selling at $10.35).
Technology bubble (1997–2000)
In 1997, the SEC adopted "Order Handling Rules" which required market-makers to publish their best bid and ask on the NASDAQ. Another reform made during this period was the "Small Order Execution SystemSmall Order Execution System
The small-order execution system was a system to facilitate clearing trades of low volume on NASDAQ. It has since be phased out and is no longer necessary.-Establishment:SOES was first introduced in December 1988 for 25 stocks....
", or "SOES", which required market makers to buy or sell, immediately, small orders (up to 1000 shares) at the market-makers listed bid or ask. A defect in the system gave rise to arbitrage by a small group of traders known as the "SOES bandits", who made fortunes buying and selling small orders to market makers.
The existing ECNs began to offer their services to small investors. New brokerage firms which specialized in serving online traders who wanted to trade on the ECNs emerged. New ECNs also arose, most importantly Archipelago ("arca") and Island ("isld"). Archipelago eventually became a stock exchange and in 2005 was purchased by the NYSE. (At this time, the NYSE has proposed merging Archipelago with itself, although some resistance has arisen from NYSE members.) Commissions plummeted. To give an extreme example (trading 1000 shares of Google), an online trader in 2005 might have bought $300,000 of stock at a commission of about $10, compared to the $3,000 commission the trader would have paid in 1974. Moreover, the trader was able in 2005 to buy the stock almost instantly and got it at a cheaper price.
ECNs are in constant flux. New ones are formed, while existing ones are bought or merged. As of the end of 2006, the most important ECNs to the individual trader were:
- InstinetInstinetInstinet is an institutional, agency-only broker. As such, it executes trades for roughly 1,500 “buyside” clients such as asset management firms, hedge funds, insurance companies, mutual funds and pension funds...
(which bought Island in 2002), - ArchipelagoNYSE ArcaNYSE Arca, previously known as ArcaEx, an abbreviation of Archipelago Exchange, is a securities exchange on which both stocks and options are traded...
(although technically it is now an exchange rather than an ECN), - the Brass Utility ("brut"), and
- the SuperDotSuperDotSuperDot was the electronic system used by the New York Stock Exchange to route market orders and limit orders from investors or their agents to a specialist located on the floor of the exchange. SuperDot was the upgraded form of the previous electronic system used to route orders, known as the...
electronic system now used by the NYSE.
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
s) possible. The low commission rates allow an individual or small firm to make a large number of trades during a single day. The liquidity and small spreads provided by ECNs allow an individual to make near-instantaneous trades and to get favorable pricing. High-volume issues such as Intel or Microsoft generally have a spread of only $0.01, so the price only needs to move a few pennies for the trader to cover his commission costs and show a profit.
The ability for individuals to day trade coincided with the extreme bull market in technological issues from 1997 to early 2000, known as the Dot-com bubble
Dot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
. From 1997 to 2000, the NASDAQ rose from 1200 to 5000. Many naive investors with little market experience made huge profits buying these stocks in the morning and selling them in the afternoon, at 400% margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
rates.
Adding to the day-trading frenzy were the enormous profits made by the "SOES bandits" who, unlike the new day traders, were highly-experienced professional traders able to exploit the arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
opportunity created by SOES
Small Order Execution System
The small-order execution system was a system to facilitate clearing trades of low volume on NASDAQ. It has since be phased out and is no longer necessary.-Establishment:SOES was first introduced in December 1988 for 25 stocks....
.
In March, 2000, this bubble burst, and a large number of less-experienced day traders began to lose money as fast, or faster, than they had made during the buying frenzy. The NASDAQ crashed from 5000 back to 1200; many of the less-experienced traders went broke, although obviously it was possible to have made a fortune during that time by shorting
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
or playing on volatility.
Techniques
The following are several basic strategies by which day traders attempt to make profits. Besides these, some day traders also use contrarian (reverse) strategies (more commonly seen in algorithmic tradingAlgorithmic trading
In electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the...
) to trade specifically against irrational behavior from day traders using these approaches.
Some of these approaches require shorting
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
stocks instead of buying them: the trader borrows stock from his broker and sells the borrowed stock, hoping that the price will fall and he will be able to purchase the shares at a lower price. There are several technical problems with short sales—the broker may not have shares to lend in a specific issue, some short sales can only be made if the stock price or bid has just risen (known as an "uptick"), and the broker can call for the return of its shares at any time. Some of these restrictions (in particular the uptick rule) don't apply to trades of stocks that are actually shares of an exchange-traded fund
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
(ETF).
The Securities and Exchange Commission removed the uptick requirement for short sales on July 6, 2007.
Trend following
Trend followingTrend following
Trend following is an investment strategy that tries to take advantage of long-term moves that seem to play out in various markets. The strategy aims to work on the market trend mechanism and take benefit from both sides of the market, enjoying the profits from the ups and downs of the stock or...
, a strategy used in all trading time-frames, assumes that financial instruments
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
which have been rising steadily will continue to rise, and vice versa with falling. The trend follower buys an instrument which has been rising, or short sells
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
a falling one, in the expectation that the trend will continue.
Contrarian investing
Contrarian investingContrarian investing
In finance, a contrarian is one who attempts to profit by investing in a manner that differs from the conventional wisdom, when the consensus opinion appears to be wrong....
is a market timing
Market timing
Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis...
strategy used in all trading time-frames. It assumes that financial instruments
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
which have been rising steadily will reverse and start to fall, and vice versa with falling. The contrarian trader buys an instrument which has been falling, or short-sells a rising one, in the expectation that the trend will change.
Range trading
Range trading, or range-bound trading, is a trading style in which stocks are watched that have either been rising off a support price or falling off a resistance price. That is, every time the stock hits a high, it falls back to the low, and vice versa. Such a stock is said to be "trading in a range", which is the opposite of trending. The range trader therefore buys the stock at or near the low price, and sells (and possibly short sellsShort selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
) at the high. A related approach to range trading is looking for moves outside of an established range, called a breakout
Breakout (technical analysis)
A breakout is when prices pass through and stay through an area of support or resistance. On the technical analysis chart a break out occurs when price of a stock or commodity exits an area pattern....
(price moves up) or a breakdown (price moves down), and assume that once the range has been broken prices will continue in that direction for some time.
Scalping
ScalpingScalping (trading)
Scalping, when used in reference to trading in securities, commodities and foreign exchange, may refer to# a fraudulent form of market manipulation# a legitimate method of arbitrage of small price gaps created by the bid-ask spread....
was originally referred to as spread trading. Scalping is a trading style where small price gaps created by the bid-ask spread are exploited. It normally involves establishing and liquidating a position quickly, usually within minutes or even seconds.
Scalping highly liquid instruments for off-the-floor day traders involves taking quick profits while minimizing risk (loss exposure). It applies technical analysis concepts such as over/under-bought, support and resistance zones as well as trendline, trading channel to enter the market at key points and take quick profits from small moves. The basic idea of scalping is to exploit the inefficiency of the market when volatility increases and the trading range expands.
Rebate trading
Rebate trading is an equity trading style that uses ECN rebates as a primary source of profit and revenue. Most ECNs charge commissions to customers who want to have their orders filled immediately at the best prices available, but the ECNs pay commissions to buyers or sellers who "add liquidity" by placing limit orders that create "market-making" in a security. Rebate traders seek to make money from these rebates and will usually maximize their returns by trading low priced, high volume stocks. This enables them to trade more shares and contribute more liquidity with a set amount of capital, while limiting the risk that they will not be able to exit a position in the stock. Rebate trading was pioneered at Datek Online and Domestic Securities. Omar AmanatOmar Amanat
Omar S. Amanat is an American who has worked as an entrepreneur in the online trading industry and in the media industry.After graduating from the Wharton School of Business at the University of Pennsylvania in 1995, he worked for a year at the online trading firm Datek Online...
founded Tradescape and the rebate trading group at Tradescape helped to contribute to a $280 million buyout from online trading giant E*Trade.
News playing
News playing is primarily the realm of the day trader. The basic strategy is to buy a stock which has just announced good news, or short sell on bad news. Such events provide enormous volatility in a stock and therefore the greatest chance for quick profits (or losses). Determining whether news is "good" or "bad" must be determined by the price action of the stock, because the market reaction may not match the tone of the news itself. The most common cause for this is when rumors or estimates of the event (like those issued by market and industry analysts) were already circulated before the official release, and prices have already moved in anticipation—the news is already priced in the stock.Price action
Keeping things simple can also be an effective methodology when it comes to trading. There are groups of traders known as price action tradersPrice action trading
The concept of price action trading embodies the analysis of basic price movement as a methodology for financial speculation, as used by many retail traders and often institutionally where algorithmic trading is not employed, and at its most simplistic, it attempts to describe the human thought...
who are a form of technical traders that rely on technical analysis but do not rely on conventional indicators to point them in the direction of a trade or not. These traders rely on a combination of price movement, chart patterns, volume, and other raw market data to gauge whether or not they should take a trade. This is seen as a "simplistic" and "minimalist" approach to trading but is not by any means easier than any other trading methodology. It requires a sound background in understanding how markets work and the core principles within a market, but the good thing about this type of methodology is it will work in virtually any market that exists (stocks, foreign exchange, futures, gold, oil, etc.).
Artificial intelligence
An estimated one third of stock trades in 2005 in United States were generated by automatic algorithmsAlgorithmic trading
In electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the...
, or high-frequency trading
High-frequency trading
High-frequency trading is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:...
. The increased use of algorithms and quantitative techniques have led to more competition and smaller profits.
Trading equipment
Some day trading strategies (including scalpingScalping (trading)
Scalping, when used in reference to trading in securities, commodities and foreign exchange, may refer to# a fraudulent form of market manipulation# a legitimate method of arbitrage of small price gaps created by the bid-ask spread....
and arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
) require relatively sophisticated trading systems and software. This software can cost $45,000 or more. Since the masses have now entered the day trading space, strategies can now be found for as little as $5,000. Many day traders use multiple monitors or even multiple computers to execute their orders. Some use real time filtering software which is programmed to send stock symbols to a screen which meet specific criteria during the day, such as displaying stocks that are turning from positive to negative. Some traders use community based tools including forums, message boards and chat rooms.
Brokerage
Day traders do not use discount brokers because they are slower to execute trades, trade against order flow, and charge higher commissions than direct access brokers, who allow the trader to send their orders directly to the ECNsElectronic communication network
An electronic communication network is the term used in financial circles for a type of computer system that facilitates trading of financial products outside of stock exchanges. The primary products that are traded on ECNs are stocks and currencies. The first ECN, Instinet, was created in 1969...
. Direct access trading offers substantial improvements in transaction speed and will usually result in better trade execution prices (reducing the costs of trading). Outside the US, day traders will often use CFD or financial spread betting brokers for the same reasons.
Commission
CommissionsCommission (remuneration)
The payment of commission as remuneration for services rendered or products sold is a common way to reward sales people. Payments often will be calculated on the basis of a percentage of the goods sold...
for direct-access brokers are calculated based on volume. The more shares traded, the cheaper the commission. The average commission per trade is roughly $5 per round trip (getting in and out of a position). While a retail broker might charge $7 or more per trade regardless of the trade size, a typical direct-access broker may charge anywhere from $0.01 to $0.0002 per share traded (from $10 down to $.20 per 1000 shares), or $0.25 per futures contract. A scalper can cover such costs with even a minimal gain.
As for the calculation method, some use pro-rata to calculate commissions and charges, where each tier of volumes charges different commissions. Other brokers use a flat rate, where all commissions and charges are based on which volume threshold one reaches.
Spread
The numerical difference between the bid and ask prices is referred to as the bid-ask spread. Most worldwide markets operate on a bid-ask-based system.The ask prices are immediate execution (market) prices for quick buyers (ask takers) while bid prices are for quick sellers (bid takers). If a trade is executed at quoted prices, closing the trade immediately without queuing would not cause a loss because the bid price is always less than the ask price at any point in time.
The bid-ask spread is two sides of the same coin. The spread can be viewed as trading bonuses or costs according to different parties and different strategies. On one hand, traders who do NOT wish to queue their order, instead paying the market price, pay the spreads (costs). On the other hand, traders who wish to queue and wait for execution receive the spreads (bonuses). Some day trading strategies attempt to capture the spread as additional, or even the only, profits for successful trades.
Market data
Market dataMarket data
In finance, market data is quote and trade-related data associated with equity, fixed-income, financial derivatives, currency, and other investment instruments. Market data is numerical price data, reported from trading venues, such as stock exchanges...
is necessary for day traders, rather than using the delayed (by anything from 10 to 60 minutes, per exchange rules) market data that is available for free. A real-time data feed requires paying fees to the respective stock exchanges, usually combined with the broker's charges; these fees are usually very low compared to the other costs of trading. The fees may be waived for promotional purposes or for customers meeting a minimum monthly volume of trades. Even a moderately active day trader can expect to meet these requirements, making the basic data feed essentially "free".
In addition to the raw market data, some traders purchase more advanced data feeds that include historical data and features such as scanning large numbers of stocks in the live market for unusual activity. Complicated analysis and charting software are other popular additions. These types of systems can cost from tens to hundreds of dollars per month to access.
Candlestick charts
Candlestick chartCandlestick chart
A candlestick chart is a style of bar-chart used primarily to describe price movements of a security, derivative, or currency over time.It is a combination of a line-chart and a bar-chart, in that each bar represents the range of price movement over a given time interval. It is most often used in...
s are used by traders using technical analysis to determine chart patterns. Once a pattern
Candlestick pattern
This page provides a brief introduction to 42 patterns of Japanese Candlesticks Chart. Candlestick pattern recognition is subjective and programs that are used for charting must rely on predefined rules.- History :...
is recognized in the chart, traders use the information to take a position. Some traders consider this method to be a part of price action trading.
Regulations and restrictions
Day trading is considered a risky trading style, and regulations require brokerage firms to ask whether the clients understand the risks of day trading and whether they have prior trading experience before entering the market.Pattern day trader
In addition, Financial Industry Regulatory AuthorityFinancial Industry Regulatory Authority
In the United States, the Financial Industry Regulatory Authority, Inc., or FINRA, is a private corporation that acts as a self-regulatory organization . FINRA is the successor to the National Association of Securities Dealers, Inc. ...
and SEC further restrict the entry by means of "pattern day trader" amendments. Pattern day trader
Pattern day trader
Pattern day trader is a term defined by the U.S. Securities and Exchange Commission to describe a stock market trader who executes 4 day trades in 5 business days in a margin account, provided the number of day trades are more than six percent of the customer's total trading activity for that same...
is a term defined by the SEC to describe any trader
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
who buys and sells a particular security in the same trading day (day trades), and does this four or more times in any five consecutive business day period. A pattern day trader is subject to special rules, the main rule being that in order to engage in pattern day trading the trader must maintain an equity balance of at least $25,000 in a margin account. It is important to note that this requirement is only for day traders using a margin account.
See also
- Direct access tradingDirect access tradingDirect access trading is a technology which allows stock traders to trade directly with market makers or specialists, rather than trading through stock brokers....
- Extended hours tradingExtended hours tradingAfter-hours trading is stock trading that occurs after the traditional trading hours of the major exchanges, such as the New York Stock Exchange and the Nasdaq Stock Market. Since 1985, the regular trading hours in America have been from 9:30 a.m. to 4:00 p.m...
- Financial instrumentsFinancial instrumentsA financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
- Fundamental analysisFundamental analysisFundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
- Futures market
- ScalpingScalping (trading)Scalping, when used in reference to trading in securities, commodities and foreign exchange, may refer to# a fraudulent form of market manipulation# a legitimate method of arbitrage of small price gaps created by the bid-ask spread....
- Stock marketStock marketA stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
- Technical AnalysisTechnical analysisIn finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...
- TraderTrader (finance)A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
- Trend followingTrend followingTrend following is an investment strategy that tries to take advantage of long-term moves that seem to play out in various markets. The strategy aims to work on the market trend mechanism and take benefit from both sides of the market, enjoying the profits from the ups and downs of the stock or...
- Day trading softwareDay trading softwareDay trading software is computer software intended to facilitate day trading of stocks or other financial instruments.-Types of software:Day trading software falls into three main categories: Data, Charting, and Trade Execution.-Data:...
- Price discoveryPrice discoveryThe price discovery process is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers ....