Day trading
From Wikipedia, the free encyclopedia
Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions will usually (not necessarily always) be closed before the market close of the trading day. Traders performing day trading are called day traders.
Some of the more commonly day-traded financial instruments are stocks, stock options, currencies, and a host of futures contracts such as equity index futures, interest rate futures, and commodity futures.
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[edit] Characteristics
[edit] Trade frequency
Although collectively called day trading, there are many sub-trading styles within the whole "day trading" tree. A day trader is not necessarily very active. Depending on one's trading strategy, it may range from several to even a hundred orders a day.
Some day traders focus on very short or short-term trading, in which a trade may last seconds to a few minutes. They buy and sell for many times, making very high trading volume daily and receiving very deep discounts from the brokerage.
Some day traders focus on momentum or trend only. They are more patient and wait for a ride on the strong move which may occur on that day. They make far fewer trades than the abovesaid day traders.
[edit] Overnight position
Traditionally it is suggested day traders should always settle their positions before the market close of the trading day to avoid the risk of price gaps (price differences between previous close and next day open that it looks like a "gap" between price activities) at the open. Some day traders consider this as a golden rule which have to stick with firmly and strictly all the time.
It is thought this rule goes against traditional market wisdom, "let the profit run". Prematurely closing a position is equal to not letting your profits run. Thus some day traders advocate it is okay to stay with a position after the market close as long as it is still in a winning position with the trend on your side.[1]
Some day traders borrow money to day trade. Since margin interests are typically only charged on overnight balances, the extra costs discourage them to hold positions overnight.
[edit] Profit and Risk
Due to the nature of leverage and rapid returns, day trading can be extremely profitable and high-risk profile traders can generate huge percentage returns. Some day traders can manage to earn millions per year solely by day trading.[2]
Nevertheless day trading can become very risky, especially if one has poor discipline, risk or money management[3]. 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, a broker usually allow more margins for daytraders. Where overnight margin required to hold a stock position is normally 50% of the stock's value, many brokers allow pattern day trader accounts to use levels as low as 25% for intraday purchases. That means even a day trader with the minimum $25,000 in his account can buy $100,000 worth of stock during the day, as long as half of those positions are exited before the market close. Thus a day trader has to admit mistakes quickly and cut losses fast when the market goes against a position.
It is commonly stated that 80-90% of day traders lose money. An analysis of the Taiwanese stock market suggests that "less than 20% of day traders earn profits net of transaction costs".[4]
[edit] Popularity
Day trading used to be the preserve of financial firms, professionals, some savvy private investors and speculators. Many day traders are professional bank or investment firms employees working as specialists in equity investment and fund management.
One of the first steps made day trading of shares potentially more profitable is to change commission scheme. In 1975, the Securities and Exchange Commission made fixed commissions illegal, giving rise to discount brokers offering much reduced commission rates.
Electronic developments further helped to promote day trading. One important step in facilitating day trading was, therefore, 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; the development of secure cryptographic algorithms etc. All have been materialized.
Day trading has become increasingly popular among casual traders due to the advance in technology, new facilities offered cheaply, and the popularity of the Internet.
[edit] History
[edit] Execution process
To understand how day trading has evolved, one must understand how stocks were traditionally bought and sold. Originally, the most important US stocks were traded on the New York Stock Exchange. A trader would telephone a stockbroker, who would relay the order to a specialist on the floor of the NYSE. These specialists would each make markets in only one to five 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.
[edit] Financial settlement period
Financial settlement periods used to be long: Before the early 1990s at the London Stock Exchange, for example, one could buy a stock one day, and only pay for it as much as 10 working days later, rather than paying for shares one could sell before the end of the settlement period reaping the profit or suffering the loss - the difference between the purchase and sale prices. Similarly, with a cooperative broker, one could sell shares at the beginning of a settlement period only to buy them before the end of the period hoping for a fall in price. This activity then was identical to day trading now, except for the duration of the settlement period. Nowadays the settlement period is typically "same day".
The reason settlement periods were reduced was to reduce market risk. Safe title is only ensured upon settlement. One's counterparty is much more likely to default if the price moves significantly against the counterparty. Reducing the settlement period reduces the likelihood of default. Reducing the settlement period was impossible until electronic transfer of ownership became possible.
[edit] Electronic Communication Networks
Thereafter, the systems by which stocks are traded have evolved along with the home computer and the internet. A number of Electronic Communication Networks (ECNs) began to form. These were 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"). The first of these was Instinet. Instinet or "inet"[5] was founded in 1969 as a way for major institutions to bypass the increasingly cumbersome and expensive NYSE, and also allowing them to trade during hours when the exchanges were closed. Ironically, 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 reason for this was that "market makers" had very few obligations to the public. A market-maker is the NASDAQ equivalent of a NYSE specialist. It 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". A pure market-maker will not care if the price of a stock goes up or down, as it has enough stock and capital to constantly buy for less than it sells. 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 ECNs 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 to sell it), while an institution would only pay a $0.05 spread (buying at $10.40 and selling at $10.35).
[edit] 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. [6] The existing ECNs did an about-face and began to offer their services to small investors. New brokerage firms began to emerge which specialized in serving online traders who wanted to trade on the ECNs. 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; in an extreme example (1000 shares of Google), in 2005 an online trader might buy $300,000 of stock at a commission of about $10, as opposed to the $3,000 commission he would have paid in 1974. Moreover, the trader would be able to buy the stock almost instantly and would get it at a cheaper price.
ECNs are in constant flux. New ones are formed, while existing ones are bought or merge. As of the end of 2005, the most important ECNs to the individual trader are Instinet (which bought Island in 2005), Archipelago (although technically it is now an exchange rather than an ECN), and The Brass Utility ("brut"), as well as the SuperDot electronic system now used by the NYSE.
This combination of factors has made day trading in stocks and stock derivatives (such as ETFs) possible. The low commission rates allow an individual or small firm to make a large numbers 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 technical 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 amounts of profits by 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". (Unlike the new day traders, these individuals 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. [7]
[edit] Techniques
There are six common basic strategies by which day traders attempt to make a profit: Trend following, playing news events, range trading, scalping, technical trading, and covering spreads. In addition to (or instead of) these, some day traders also use Contrarian (reverse) strategies (more commonly seen in Algorithmic trading) to trade specifically against irrational behavior from day traders using these approaches. Some of these approaches require shorting stocks instead of buying them normally.
[edit] Trend following
Trend following, a strategy used in all trading time frames, assumes that financial instruments which have been rising steadily will continue to rise, and vice versa. The trend follower buys an instrument which has been rising, or short-sells a falling one, in the expectation that the trend will continue.
[edit] Range trading
A range trader watches a stock that has been rising off a support price and 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 sells) 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.
[edit] Playing news
Playing news 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 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 said to be already "priced-in" to the stock price.
[edit] Scalping
Scalping originally referred to spread trading. Scalping is a trading style which arbitrage for small price gaps created by the bid-ask spread. It normally involves establishing and liquidating a position quickly, usually within minutes to even seconds.
[edit] Shorting stocks
About 75% of all trades are to the upside. The trader buys it and expects it to rise, because of the stock market's historical tendency to rise and because there are no technical limitations on it.
About 25% of equity trades, however, are short sales. 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 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).
[edit] Cost
[edit] Trading equipment
Some day trading strategies (including scalping and arbitrage) require relatively sophisticated trading systems and software. Many day traders use multiple monitors or even multiple computers to execute their approaches.
A fast Internet connection like Broadband is a must for day traders.
[edit] Brokerage
Day traders do not use retail brokers. They are slow to execute trades, and for the scale of order size the typical day trader operates on the commissions are high. What day traders prefer are direct-access brokers who allows the trader to send their orders directly to the ECNs instead of indirectly through brokers. Direct-access trading offers substantial improvements in transaction speed and will usually result in better trade execution prices (reducing costs of trading).
[edit] Commission
Commissions in direct-access brokers are calculated based on volume. The more one trades, the cheaper the commission is. Where a retail broker might charge $10 or more per trade regardless of size, a typical direct-access broker can charge as cheap as $0.004 per share traded, or $0.25 per futures contracts. A scalper can easily cover that cost even with a minimal gain.
As to the calculation method, some use pro-rata to calculate commissions and charges, where each tier of volumes charge different commissions. Other brokers use a flat-rate, where all commissions charges are based on which volume threshold one reaches.
[edit] Market data
Real-time market data is necessary for day traders, rather than using the delayed market data (from about 10 to 60 minutes of delays per exchange rules[8]) that is available for free. A real-time data feed requires paying fees to the respective stock exchanges, usually combined into whatever fee the broker charges; these fees are usually very low relative to 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 better historical data and features like 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 anywhere from tens to hundreds of dollars per month to access.
[edit] Spread
- See also: Scalping
Most worldwide markets operate on a Bid and ask based system. The numerical difference between the bid and ask prices is referred to as the spread between them.
The ask prices are immediate execution (market) prices for quick buyers (ask takers); bid prices for quick sellers (bid takers). If a trade is executed at market prices, closing that trade immediately without queuing would not get you back the amount paid because of the bid/ask difference.
Spread is 2 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.
[edit] Regulation and restriction
[edit] Suitability
Day trading is considered a risky trading style, it is not suitable for everyone. To prevent complete beginners or ignorant traders from entering into the trading market, regulations require brokerage firms to ask whether the clients understand the risks of day trading and whether they have some prior experiences on trading.
[edit] "Pattern day trader" amendment
In addition, NASD and SEC further restrict the entry by means of "pattern day trader" amendments. Pattern day trader is a term defined by Securities and Exchange Commission 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 is that in order to engage in pattern day trading you must maintain an equity balance of at least $25,000 in a margin account.[9]
[edit] Views of day trader
Day traders, with modern technology and recent regulatory changes (within the last 15 years), have cut in on the market makers' business action and taken a piece of the pie for themselves. Some see this as causing frustration amongst investment banks, who are thought to vilify day traders in the press. Day traders are sometimes portrayed as "bandits" or "gamblers" which is thought to discourage others from joining in on the activity.
On the other hand, others see the phenomenon of day traders as primarily created by the stock brokerage community, in order to get people to constantly trade more stocks, and to thereby pay more commissions. These critics see this as applying to business news and stations such as CNBC, which is seen as relevant primarily to day traders.
Lastly, some argue that day traders serve a valuable purpose by contributing liquidity to the marketplace. In the course of entering many buy and sell orders throughout the day, day traders add to the number of people who want to either buy or sell a security, and therefore increase the number of shares bid or offered. In addition, day traders might even help to move a particular security closer to market equilibrium (the point at which supply and demand are equally balanced, or the "true" price of a security) by reducing over-corrections in price. As a security moves up in price too rapidly, for example, a day trader might step in and short the security, thereby providing some downward pressure. If a security moves down in price too rapidly, a day trader might provide some support by entering a buy order.
[edit] See also
[edit] Other trading style or method
- Direct access trading
- Scalping
- Swing trading
- Trend following
- Fundamental analysis
- Technical analysis
[edit] Other people
[edit] Other item or place
[edit] External links
- Day Trading Article For Currency Market
- Day Trading Article by Investopeda
- Day Trading Strategies by Investopedi
[edit] Notes and references
- ^ One trader who advocates this is called Johnson, found in a book titled Trading Strategies for Direct Access Trading - making the most out of your capital
- ^ Day trader Paul Rotter is profiled in Trader Monthly.
- ^ US government warning about the dangers of day trading
- ^ Barber, Brad M., Lee, Yi-Tsung, Liu, Yu-Jane and Odean, Terrance, "Do Individual Day Traders Make Money? Evidence from Taiwan" (January 2005). [1]
- ^ ECNs and exchanges are usually known to traders by a three- or four-letter designator, which identifies the ECN or exchange on Level II stock screens. ECNs are identified in small letters: For example, Instinet is inet, Brass Utility is brut, Arcanet is arca, Arcaex is ARCA, Bloomberg is btrd, Island used to be isld.
- ^ Another reform made during this period was the "Small Order Execution System", or "SOES", which required market makers to buy or sell, immediately, small orders (up to 1000 shares) at the MM's 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 more cynical reader might be amused to know that Charles Mackay's classic Extraordinary Popular Delusions and the Madness of Crowds, written in 1841 about the Dutch Tulip mania of the 1600s, enjoyed a resurgence of popularity among traders.
- ^ HKFE requires 60 mins of delays. For others, see "Exchange Requirements for Delayed Market Data"
- ^ Website that explains NASD Rule 2520 the Pattern Day Trader Rule
