One of the most controversial topics on Wall Street is day trading. Some experts urge investors to stay away from day trading strategies, while others swear by them. Despite the wide range of opinions on the subject, several day trading strategies are as popular today as they’ve ever been.
What Is Day Trading?
Day trading is simply the practice of buying and selling stocks to capitalize on short-term, market-driven fluctuations in share prices. People who are day trading have a different approach than long-term investors, who buy a stock and hold it for months or years, hoping that changes in the company’s underlying fundamental performance will ultimately impact its market valuation.
There are a number of popular day trading strategies that each involve a unique approach to the market.
Momentum trading is for day traders who typically rely on technical analysis rather than fundamental analysis. Fundamental analysis of a stock involves identifying buying opportunities based on the company’s underlying business metrics, such as its earnings, revenue and debt. Technical analysis involves analyzing only the recent fluctuations in a stock’s price and identifying buy-and-sell signals in its stock chart. These buy-and sell-signals can include formations, trends, patterns or other metrics, but all of the signals are ultimately based on the stock’s recent trading history.
Day traders who use momentum trading buy a stock when it breaks out of a pattern to new highs or lows. Those new highs may be on a daily, hourly or even five-minute basis, but these day traders see a stock breaking into new territory as an opportunity to capitalize on short-term bullish or bearish momentum. Momentum traders aren’t concerned with buying at exact low points and selling at exact high points, but rather want to get into a stock that is already moving and get out before it reaches an inflection point.
Scalping is another trading strategy. These traders sell stocks almost immediately after buying them to earn a profit. Scalpers focus on quantity over quality, hoping that dozens of modestly profitable trades will eventually add up to large overall returns. Most scalp traders are aiming to capture less than 1 percent moves in stock prices and will enter and exit a trade in a matter of minutes.
Scalping is a very defensive strategy akin to filling a gallon jug of water a few drops at a time. To beef up gains and offset the cost of trading commissions, scalpers often trade in large orders. They also set tight stop orders that exit the trade as soon it begins to fail. Scalping is a strategy that requires consistency. Just a handful of modestly profitable trades in day may not generate enough overall return to be worthwhile.
Scalpers must have access to real-time trading data and stock charts to make this strategy work. Capitalizing on such small moves with share prices requires precise timing and a clear exit strategy.
Swing trading is a strategy, in which traders identify short-term patterns and trends in stock prices and then trade based on the assumption that these patterns will continue in the near term. For example, swing traders may identify levels at which a stock has peaked in the past two weeks and assume that it will continue to peak near that level. Once identified, those levels would potentially represent good prices when to sell or short sell the stock.
Rob Friesen, president and chief operating officer of Bright Trading, says identifying consistent patterns and relationships requires data, not simply playing a hunch.
“Most traders don’t sample enough, or have enough funds for the learning curve, in order to develop into a trader that has that great feel for things,” Friesen says.
Friesen says buying and selling stocks based on personal opinions rather than data and knowledge is a losing battle. “We do not believe that a point-and-click trader with limited capital can make a living from the market in today’s efficient, algo-driven environment,” he says.
Market-neutral trading is a relatively defensive strategy, in which a trader attempts to hedge a trade by taking one long position and one short position in two related stocks or other securities. The goal of a market-neutral strategy is to capitalize only on the relative performance of one stock compared to another, while offsetting any risk associated with overall sector or market weakness.
Dennis Dick, proprietary trader and market structure analyst at Bright Trading, says he mitigates risk in his trading by focusing on market-neutral day trading strategies.
“The goal is to try to eliminate the overall market risk, which is essential in the current market environment,” he says. “Even if a stock has good relative performance, if the overall market has a significant decline, I am likely to lose money on that trade.”
Friesen says understanding the relative prices of companies with different classes of stocks, such as the A-shares and B-shares of BHP Billiton (ticker: BBL, BHP), is a great starting point for market-neutral traders.
A Warning About Day Trading
If given the choice, anyone would rather make big profits in a day or two rather than a year or two. Unfortunately, like many other endeavors with the potential to earn vast amounts of money in very little time, day trading isn’t as easy as it looks. In fact, according to Vantage Point Trading, as many as 95 percent of day traders ultimately end up losing money.
Owen Murray, director of investments at Horizon Advisors, says investors who want guaranteed returns in the long term should simply avoid day trading all together. Murray says for most investors, there’s no difference between day trading strategies and gambling at a casino. He also says bull markets tend to make day traders look more skilled than they actually are.
“Day trading typically becomes very popular during bull markets, because on balance, stocks are mostly moving higher and it is easier to make profits,” Murray says. “But in most cases, investors are better served by creating a well-balanced, long-term portfolio, rather than racking up trading expenses and costly short-term capital gains.”
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