Day Trading: Is It the Right Investing Style for You?
If you’re an investor, and even if you’re not, you’ve probably at least heard of day trading.
It’s that seemingly magical investment strategy that “anyone can do” and find instant riches.
While there are undoubtedly a few day traders out there who have hit on success, even on a big-time level, they’re heavily outnumbered by the many more who have tried and failed.
That’s hardly unusual, considering the many obstacles to day-trading success.
If you’ve been wrestling with the idea of becoming a day trader, or you’re just casually interested, here’s a primer on what’s involved.
What is Day Trading?
Day trading is just what the name implies – buying and selling stocks on a daily basis. You may sell the same stock in the afternoon you bought in the morning. You may do that several times a day.
The basic theory behind day trading is taking advantage of price swings.
We’ve all heard the saying “buy low, sell high”.
That’s exactly what day traders do, but instead of buying and holding stock for several years to get long-term gains, they opt instead for small gains on a daily basis.
To make it work profitably, day traders need to be constantly trading.
They may make $150 on one trade, $100 on the next, then lose $75 on the third. At the end of the day, they’re up by $175.
The long-term outlook
The key is to trade every day, producing small daily profits that add up to substantial money at the end of the week, month, or year.
It’s all based on stock price arbitrage. Stock prices constantly rise and fall, even within the space of one day.
If you can buy 1,000 shares of a stock at 32 ¼ in the morning, then sell it at 32 ¾ in the afternoon, you’ll earn $500 on the trade.
Since stock prices do fluctuate throughout the day, taking advantage of these small changes is possible.
Deciding on trades
Day trading does involve having considerable knowledge about the price behavior of the stocks you’re trading.
This includes having access to a considerable amount of technical analysis that might tip you know when to get into a stock, as well as when to get out.
And as is the case with every endeavor, the longer you do it, the better you become.
That’s why the most profitable day traders are usually the most experienced.
Is Day Trading illegal or a Scam?
Let’s address the first part of that question – is day trading illegal?
The answer to that question is no.
Day trading is perfectly legal.
Scams related to day trading
Is it a scam?
Technically speaking, however, day trading is not a scam.
However, the average person doesn’t have the high-risk profile and willingness to “learn the ropes” necessary to become successful. Most also lack the time required and the capital necessary.
Some people do report incredible success with the practice. As long as there are some success stories, day trading profitably isn’t a scam.
Unfortunately, for many prospective investors, this isn't common.
That may lead people to fall for investment scams related to day-trading.
This may include:
- investment clubs
- trading and analysis tools
- stock tips
- training courses
A safe investing style?
For most people, the answer is a certified “no”.
While it might be possible to make a lot of money day trading, at least in theory, most people won’t.
The greater likelihood:
You will lose money -- possibly a lot.
The practice is even riskier by virtue of the fact that it typically involves leverage.
That’s where you use margin to purchase stock.
For example, if you buy 1,000 shares of stock at $20 your total investment is $20,000. But if $10,000 of the purchase price is borrowing on margin, you’ll only need to put up the remaining $10,000.
If the investment goes in your favor, you’ll make twice as much money on a $20,000 investment than you will on a $10,000 investment. But if it goes against you, you’ll lose twice as much money on the $20,000 investment as you will $10,000 investment.
Speaking of “investment," day trading is categorically not investing. An investor typically puts money into a company for the long-term, looking for growth.
A day trader’s play is purely on short-term price movements.
Pros and Cons of Day Trading
- For those who know what they’re doing and have the time and money to invest, it offers an opportunity to earn outsized returns on your money.
- If you’re legitimately good it, you may be able to create a day trading course to sell to others.
- It can be an opportunity to make money without leaving home, making it an option for students and retirees.
- You can lose everything you have, particularly if you use leverage in your trading activities.
- There’s a long and treacherous learning curve, as you enter the practice. You can take a training course, but it still takes a lot of good old-fashioned “trial by fire”.
- You can do well for a long time, then get wiped out in a few days if the market goes against you in a major way.
- Since day trading involves very active trading, you’ll pay a fortune in trading commissions.
- You may also incur significant costs for both training programs and special trading and investing tools needed for the practice.
- Gains on day trades are subject to ordinary income tax. You won’t get the benefit of more favorable long-term capital gains tax rates.
- Because of the sheer volume of trades during the course of the year, keeping accurate records can be overwhelming.
- You’ll need a lot of money. That will include money for your day trading activities, as well as a large portfolio of more stable investments. You should never want to day trade with money you can’t afford to lose.
- Day trading can be incredibly stressful even when it’s working out for you. But it will be even more so if the market turns against you.
How to Start Day Trading
You’ll first need to open an account with a broker that provides all the investment services you need.
You’ll also need to be certain that broker will accommodate day trading, as not all will.
The brokerage account will also need to be a margin account, which will give you access to borrowed funds. This may be necessary unless you have sufficient capital to actively trade without borrowing.
Few if any brokerage firms have educational resources for day trading because of its speculative nature. But you will need some sort of training, which will have to come from an outside source.
Be careful in choosing any type of day trading training courses.
Most are put out by day-trading promoters, who are more interested in selling you their courses than teaching you how to be successful (if they even know).
One of the major disadvantages of day trading is that it involves short-term trading.
That means the income generated from your trades will be taxed as ordinary income.
The profits will be subject to your regular marginal tax rates.
Different from long-term capital gains
On long-term capital gains, those where you hold the securities for more than one year, you’ll get the benefit of more favorable long-term capital gains tax rates.
These tax rates will be well below the rates you will pay on ordinary income, and many taxpayers will have zero liability on long-term capital gains.
If you lose money on your day trading activity, you’ll be limited to how much you can write off on your tax return. This is generally no more than $3,000 in losses in any one year.
However, any excess may be carried forward into future years, or even deducted against future capital gains income.
If you’re a day trader, or plan to be, you’ll need to work closely with a good CPA.
Should You Day Trade?
For the average person, the answer to this question is a definite "no."
The practice is too risky and unpredictable.
It’s more likely to produce losses, even very large ones, that can threaten your financial survival.
Also, remember that day trading is not investing, but more of an occupation. It requires sitting in front of a computer for several hours each day and tracking stock price movements in minute detail.
The practice is best reserved for those who fully understand the risks they’re taking on, have the knowledge and experience needed, and a large enough portfolio that they can afford to absorb substantial losses from their day trading activities without becoming financially impaired.
Unfortunately, there’s more than a little bit of hype surrounding day trading, which attracts thousands of people to the practice each year.
But if you have any thoughts of joining them, be sure to do your research.
Pay close attention to reports and forums provided by people for whom the practice did not work out.
If you’re going to become a day trader, you’ll need to go into it with your eyes wide open.