Day trading is a fast-paced, technically demanding and potentially lucrative form of investing. It carries prestige and risk in equal measure. This is the Financial Expert beginners guide to day trading.
You may have seen YouTube videos, articles or guides on how to get rich by day trading. This article will offer a more holistic and balanced view than that glossy, marketing message.
Warning: Day trading is a high-risk investment activity, and is not a simple alternative to buying shares or investing in property. Day trading is considered high risk due to the high volatility of short term markets, the impact of investing costs, and leverage which can be offered by some brokers. When trading with leverage, investment losses can actually exceed your original investment amount.
In general, day trading is not recommended for beginners to investing. Day trading should only be performed by:
- Sophisticated investors
- Individuals with a relevant professional background
- Enthusiasts who are satisfied that they have gained enough knowledge through relevant investing courses and other experience.
You should only invest with money you can afford to lose. This guide is a piece of financial journalism and does not replace advice from a financial adviser. Please seek financial advice if you are unsure about any investment you wish to make.
Day trading – a beginners guide
This beginners guide won’t teach you everything you need to know before you begin day trading. That article would probably have to be over a million words long.
Instead, I will attempt to give an overview. My objective is to signpost you to the many topics you should master if you’re serious about getting started as a day trader. By the end of this guide, you’ll know what you need to know.
- What is day trading and why it has become popular online
- The practical steps to get started as a day trader
- How day traders actually make money on the financial markets.
- This is a balanced article, so I’ll also explain the drawbacks to day trading.
- The realistic returns you would expect as a day trader
- Maintaining healthy skepticism when performing further reading about day trading on the web.
Ultimately, and this cannot be repeated enough – day trading is not suitable for everybody.
In fact, I’d go as far as to say that it’s only suitable for a small minority of investors. The vast majority would probably be financially better off by buying shares, or a cheap equity ETF and corporate bond fund and waiting patiently until their retirement date. This might be the case for you.
What is day trading?
Day trading is the buying and selling of financial instruments over a very short time period. I’m talking about positions held for between a handful of seconds to a few hours.
The different types of markets could include:
- Stocks & shares on the stock market
- Currencies on the forex market
- Bonds on the bond market
- Commodities on the commodities market
The instruments could represent direct holdings in the assets themselves, or they could be derivatives. Derivatives are contracts between two counterparties, which are valued on the basis of an underlying asset, such as the share price of a company.
Examples of derivatives include forward contracts, options, and futures.
Sometimes a financial instrument can blend the two. You could buy an exchange-traded note, which is a direct investment in a collective investment vehicle which holds derivatives. If you think that sounds confusing, this is the tip of the iceberg!
Day traders tend to specialise in a particular instrument in a particular financial market, for example, they’ll invest only in gold or they’ll be a bond trader who doesn’t touch the stock market.
This specialization makes a lot of sense, for reasons I’ll cover below. But there’s no need for you to specialise yet – I recommend you keep your education as broad as possible until you’re much further down that road.
Further reading: How to trade forex.
Why do people day trade?
People day trade because they believe that their combination of intellect, analysis, nerve and discipline will allow them to make better investment decisions than the average market participant. They believe they can generate alpha – see our definition below.
Day trading provides independence, compared to being an employee. Day traders don’t have defined working hours, don’t have a boss, and each trader will have refined a schedule that works for them. Day traders are effectively self-employed.
Day trading can at times be an exciting profession. The soaring euphoria of seeing a position swing into the money, or the glee at finding a secret edge that you can exploit for the rest of the year. These are highs that a desk job would struggle to match.
People also day trade because they lament passive investing, and want to actively work with their money to achieve the highest possible return on investment. Other day traders or active fund managers have proved that this is possible for years or decades at a time.
What is alpha?
Day traders continuously seek alpha. Alpha is the name given to the return generated separately to the underlying ‘expected return’ of the stock market (which is known as beta). In other words, alpha is your trading profit or loss in excess of the average market return.
Every day trader has the option to passively leave their money in an index fund to earn the market average, so alpha is the only element of return which rewards the day trader for their efforts. It’s the salary of a day trader, after deducting trading costs and other fees.
A day trader doesn’t need to be the best trader on the market – they only need to be better than average. Because of fees and other inefficiencies, they must exceed the average by some margin before they can generate a personal alpha.
How does day trading differ from investing?
The differences between day trading and ordinary investing are subtle but significant.
A long term investor will hold an investment for 5 years or more (perhaps as long as their time horizon will allow). For long term investors, the longer you can hold an investment, the higher the likelihood that it will return a healthy average return.
This concept is turned upon its head by day trading. Day traders make money from the volatility, the short term ‘noise’, and frankly the carnage of short term price movements.
Long term investors seek to ignore short term price movements altogether, whereas day traders hope to skillfully ride the prices like a rider at a rodeo.
Day trading positions could be open for just a few seconds or minutes, depending on the nature of the trade.
The long and short of it
Long term investors generally buy an investment and hold it. Being owners of the asset, they hope that its value will appreciate over time. This is also known as being ‘long’ on the asset.
Day traders aren’t constrained to this technique. Using several methods, they can actually make a profit from the price of an asset falling. This is known as taking a short position.
The classic way to do this is to ‘borrow’ the asset in question and sells it at the current market price for cash. This is an obscure sounding arrangement but is facilitated by specialist brokers.
By borrowing the asset, the trader has taken the opposite of an ownership stake. If the value of the asset now falls, the trader only needs to spend a part of their cash proceeds to buy it back (and repay the broker with the same quantity of the asset). The cash leftover is their profit.
Of course, if the price of the asset increased, then the trader would need to spend more to buy back the asset than they originally generated from the sale, resulting in a loss.
Depending on the trading platform and type of financial instrument, traders can take short positions in a number of different ways. Often, taking a long or short position takes an equal number of clicks.
Dividends… what dividends?
For investors, dividend income is a vital component of the total investment return from investing in equities. However, day traders are only in the market for short periods and may take positions which entitle them to zero (or minimal) dividends.
After all, dividend income and growth is just a part of beta – the underlying market return. Maximising beta is not the objective of a day trader.
How to day trade – an introduction
So let’s move onto the practical part of this guide. How do you day trade? I’ll explore the techniques that day traders use to generate alpha, and the steps you would need to take to get started.
Day trading investing styles
With the market moving up or down virtually on a coin flip, even a monkey can be lucky and have some short-term success in the market (much like a gambler can do well in a casino on a night).
A day trader needs to rely on more than just luck, they must have a coherent investing approach which allows them to identify and then take advantage of small mispricings in the market.
I will give an overview of the main investing approaches adopted by day traders:
1. Technical analysis
Technical analysis is the application of rigorous analysis to historical pricing or other data to generate a prediction about price movements.
This remains a contentious investing approach, despite being practised in a widespread manner by day traders. This is because it violates the principle of the efficient market hypothesis.
The efficient market hypothesis, in a nutshell, states that a trade should not expect to be able to make a profit from any publicly available information, because this information has already been digested by market participants and is therefore reflected in the current market price.
Technical analysis runs contrary to this view, because it is based on the assumption that an investor can consistently guess future price movements more often than not, on the basis of information which is already ‘out there’. This implies that the current market price has not yet fully reacted and absorbed all information.
Like other investing approaches, chart reading is very difficult in practise.
When reading quantitative analysis books, the winning trades can look blindingly obvious with the benefit of hindsight.
Authors can also be highly selective in the examples and case studies they choose to use, which can give a misleading impression of how often the rule actually works.
Ultimately when you’re in a live trading session, staring at the blank end of the graph, wondering which way the candlestick chart bar will move next, you’ll discover how difficult this is.
Arbitrage is a clever investment strategy which involves making a low-risk profit from the mis-pricing of similar or identical assets sold in different places.
An example of arbitrage in the real world, might involve a buyer purchasing iPads in New York, and immediately selling to a UK buyer for a higher price. The trader is taking advantage of the lower RRP in the US and the higher prices in the UK.
Any mispricing of the same product in two markets provides an arbitrage opportunity to buy low and sell high simultaneously.
As the trader doesn’t technically own the product for more than a moment, they’re not exposed to the risk of price movements. So long as the trades can be executed at a cost less than the price differential, then the trader has locked in a risk-free profit. This is alpha at its purest.
Arbitrageurs might need to get into the detail of complex financial products to spot an opportunity. For example, if the market value of an exchange traded fund is trading at a discount to the underlying prices of its individual investments, they may choose to buy shares in the ETF, and simultaneously sell the individual constituents of the ETF portfolio.
Again, if calculated and executed correctly, the trader can again take a neutral position in the underlying assets, whilst generating a small profit.
Due to the efficient mechanisms of modern markets, and the impact of arbitrage seekers, large opportunities simply do not exist. Modern arbitrage is usually about finding a small but solid opportunity, and executing at a large scale to generate a meaningful return.
When a positive piece of news is announced about a company, the prices of its shares tend to increase in response. Any trader who can process this news and execute a trade in advance of other traders, may be able to generate a low-risk profit from the subsequent movement.
Realising profits from this method is far harder than it sounds. Traders have been racing each other over the decades to react and execute in lightning fast speeds. The best systems for doing so as now completely automated systems which can process news and place trades in less than a second.
But the news isn’t the only event that causes price movement in the market. Unusual volume, changes in prices of similar assets traded elsewhere, and economic conditions can all result in price changes, providing plenty of very short term opportunities for day traders to skim a small profit off the top of these movements.
Some day traders find an edge through information. Insights or information which isn’t known or public provides a consistent trading advantage, as it cannot possibly be already factored into prices.
However day traders must tow a fine line with informational advantages.
Placing trades on the basis of inside information is a crime in most countries. In the UK, inside information is defined as information which:
- has not been made public
- directly or indirectly relates to one or more issuers, or to one or more financial instruments and
- if it were made public, would be likely to have a significant effect on the prices of those financial instruments, or on the price of related derivative financial instruments
An example of inside information might be knowledge of the financial results of a company before these have been released to the market in an annual report.
Therefore, day traders who wish to own an informational edge need to perform unique and independent financial analysis of company fundamentals. This is the only legal way to generate ‘new information’ which isn’t in breach of the Market Abuse Regulations.
Maintaining the edge
Whichever investing approach you take, maintaining your edge will be a continuous pursuit.
A trading idea can have a short shelf life:
- The trading opportunity might only exist for a fleeting second
- The trading idea may have a limited amount of liquidity. In other words, you can only throw a certain amount of cash at the trade before the impact of that trading moves prices and eliminates the opportunity completely.
- Other traders can discover the same idea and use up the remaining liquidity by following the same trade themselves.
Even renowned traders or fund managers have admitted that the relentless pursuit of the next trading idea is an all-consuming worry. They can rarely sit on their laurels and watch as their funds outperformed for months due to a single idea.
Getting starting in day trading:
1. Investing courses
Education has to come first. The markets are highly efficient and highly competitive. With a virtually unlimited pool of capital and thousands of brains chasing the same goal, you need to be a master of the markets to achieve and maintain an edge.
We feature several advanced investing courses on our investing courses page, such as :
- The CISI Accredited Online Trading Programme – in association with the London Stock Exchange
Further reading: The best investing courses for day trading
Investing psychology is very important to day trading. Being a day trader can be a very lonely experience.
No one can make your financial decisions for you, and no one will share your wins or losses.
It can be helpful to find a well-meaning group of fellow traders. This can allow for the sharing of ideas (where this is wise…), emotional support and can provide a degree of structure to the trading experience.
For this reason, day traders can rent trading desks at shared office spaces to foster the kind of collegial atmosphere found at an investment bank.
It’s great to mix with a group of like minded people – however you will need to be careful and selective. They need to have your best interests at heart. Traders aren’t known for being altruistic, and it’s easy to imagine a trader attempting to take advantage of their peers by encouraging fellow traders to bail them out of bad trades or support shaky ones.
Also could develop group think – it’s comforting to go with someone else’s decision or rely blindly on a person’s (apparently) successful history but this doesn’t mean that they have an edge.
Further reading: Investing psychology: dealing with loss
3. Starting capital
How much capital you begin your day trading journey with is incredibly important. Day trading is a game of percentages, but whether you can earn enough to stay solvent during a period of poor returns, and also support yourself financially, is also a function of the size of your portfolio.
If you can generate a 20% annual return, this could translate to £10,000 per year or £1,000,000 per year. It’s only a question of how much capital you can use to back each trade.
It is sad to imagine a trader who spends weeks creating and executing several successful trading ideas, only to fail to back the trade with enough capital to actually leverage a reasonable return.
Depending on your country, there may actually be a legally required minimum capital.
In the US, this is $25,000 if you meet the ‘pattern day trader’ definition of the SEC and want to use a margin-based account. This is probably something that you’ll want to do if you’re trading frequently and don’t want to wait 2-3 days for trades to settle in cash before you can use those funds again.
Of course, the inescapable fact is that we cannot simply choose how much we’d like to start with. We’re constrained by our own financial situation.
That being said, if you are unable to create a large enough starting balance, then you cannot hope to generate a high enough return to provide for your financial needs.
If you were hoping to invest very little money and turn it into a small fortune, day trading is not for you. Yes, professional traders might make millions, but they usually have access to millions of trading capital to do so.
4. Position size
Just as important as your starting capital, is the question of what percentage of your cash pile should you stake behind each trade.
It’s helpful to consider this simple scenario:
You are offered a wager on a loaded coin. The coin has a 66% chance of landing heads, and a 33% chance of coming up tails. You have £100, and 10 opportunities to play the game.
What will be the size of your first bet?
This is a fairly simple scenario, but it comes with a very complicated answer.
To maximise your expected return per coin toss, you will want to increase the size of your bet. Afterall, if you only wager £1 per toss, the most you could hope to make from 10 spins is a few pounds.
However because there’s still a very real risk of landing tails several times in a row, you wouldn’t want to wager too high a percentage of your pot, for fear of being wiped out by an unlucky sequence.
This problem maps perfectly onto the day trading dilemma. Even if you have a trading edge, you can still go bust if you wager too much of your portfolio. But if you play it too safe – you’ll squander the economic benefits of having the edge in the first place.
It’s a very careful judgement call, which will need to be tailored according to the risk of the trade, the potential payoff, and the number of other opportunities you may have to execute it again.
5. Choose a stockbroker
As a day trader, your stockbroking needs will be more demanding than a simple buy and hold investor who wants to own a few shares.
In fact, even an adventurous investor who invests in emerging markets, IPOs and structured products would be satisfied with a relatively simple stockbroker account. The needs of a day trader far surpass this.
Your focus will probably be in getting the best price on execution, with the lowest trading commissions for high frequency clients.
Comparing stockbrokers on the basis of fees is quite a simple task as all reputable brokers are very transparent about their fees and charges for various services.
As mentioned above, day traders will often choose a stockbroker which allows them to trade on margin, which is a form of credit.
This isn’t necessarily about borrowing money to leverage bets. Margin accounts offer a smoother experience from a cash flow perspective. All equity trades, for example, take 2-3 days to go through the settlement process to result in a cash movement.
This would certainly hold up the activity of a day trader who wants to trade multiple times per day. By offering a line of credit, a broker can continue to allow the day trader to buy instruments. This is a relatively low-risk line of credit because the broker is only lending against the value of incoming cash, therefore the interest charges are reasonable.
Alternatively, some day traders use spread betting platforms to invest. Spread betting platforms do offer a straightforward user experience, however this method of trading incurs higher costs.
Further reading: Investors guide to spread betting
6. Trading software and charting software
If not already provided by your stockbroker, any day trader will need access to pricing charts and plenty of market data.
All day traders would expect level I market data, this consists of live bid and ask information.
An example of level I information is seeing that the lowest available price you can buy a share in your target company is £8.30.
However, technical analysts and arbitrage traders will also require level II data as well.
Level II is known as market depth data, and reveals not just the highest current buying price but the other (slightly poorer) offers behind it. This will tell you what price is available at what level of liquidity.
To return to the earlier example, the best offer might be £8.30 for 10,000 shares. However, if you wanted to buy more than 10,000 shares, you’d be matched with the next best offer of £8.50. Level II data gives this visibility over the full order book on both the buy and sell side.
You can see how this is very useful to a day trader. A live price might give the impression that a large arbitrage opportunity exists. But without sufficient liquidity at the best price, the maximum size of your trade may be quite limited.
Further reading: The difference between level I and level II market data
7. Research & company news
A day trader needs to keep their finger on the pulse of the market, and this includes the news and supplementary information which keeps the pulse beating.
The two big names in financial information and news are Thomson Reuters and Bloomberg.
These are best-in-class services, but come with an eye watering price. Quartz reported in 2013 that Bloomberg (which is quite secretive about its pricing) charges a minimum of $20,000 for an individual subscription, for a single year.
This is not going to be a viable option for a smaller day trader who is just starting out. $20,000 could be a large chunk of their starting capital!
Of course, this is the age of the open web. Share prices and company information can be accessed through much cheaper platforms, and the major newswires don’t have quite the same grip over live news that they once had.
Further reading: How to research share prices and company information.
8. Backtesting software
Once you have an idea for an investing strategy – how can you test whether it will work without putting your capital at risk immediately?
The answer is through back testing. Back testing is where you run a simulation through historical market data.
The question you’re asking is if I had tried this investing strategy 5, 10 30 or 100 years ago…
- Would it have generated a market-beating return?
- In what proportion of years would it have turned a positive return?
- What would the average return have been?
Some trading software actually includes backtesting functionality.
All you need to do is provide a clear series of rules for what type of securities to buy and when to sell. Then you can leave the software to run through a hindsight simulation and tell you whether this would have made money in the past.
This method is most appropriate for criteria-based strategies which could be followed easily by an algorithm. Such as:
- Buy any share which has fallen more than 30% from its 3 month average
- Buy any A+ rated corporate bond issued by a tech company when its yield to maturity rises above 6%.
At first, back testing might sound like a water-tight method for testing a theory, but a positive backtesting result won’t actually give you 100% assurance that a trading strategy will work.
This is for several reasons:
- Even 100 years of stock market data is not actually as large a data set as it might seem. The trading strategy may have only worked because of chance.
- The particular events of the last 100 years may not repeat in a similar fashion. Historic data will include the effects of rare and unusual events such as financial market regulations, large financial scandals and one-off demographic shifts or technological developments.
- Back testing might show that an investing strategy would have worked, but it doesn’t explain why. It proves a correlation between some element of the trading strategy and marketing pricing, but it doesn’t necessarily prove the casual relationship that the day trader is assuming.
For example, a trader may test a strategy of buying stocks in January of each year and selling in November.
Backtesting may show that this was a profitable trade, but this doesn’t prove that the calendar months themselves were the cause.
Something else may have been triggering the market movements, which happened to occur in January or November. Without this insight, the day trader may not appreciate that they are in a year when that mystery event has actually not taken place in January as normal.
Day trading tips
Here are some further day trading tips which could help you avoid the mistakes made by many traders when entering this game.
Cost is king
If you need to pay even £2k per year for access to a trading platform, then that’s £2k of returns you’ll need to generate just to break even.
A useful way to frame this is to consider your operation like a struggling business. Unless you’re already an accomplished day trader, you don’t have the luxury of ‘spare margin’ to frivolously spend on luxuries.
Challenge every cost. Every pound or dollar spent on fees or services, will require a pound or dollar of extra returns just to break even.
Don’t forget about tax
Within a day trading account, you won’t have the carefree convenience of trading in a tax-free environment such as a Stocks & Shares ISA or a 401(K). Capital gains and other investment income will be subject to taxes in your country, therefore be sure to understand the rules that apply to you before you begin.
Avoiding taxes where possible is always desirable, so have this in mind from the beginning when choosing your investment account and method of trading.
Who is your competition as a day trader?
In your battle to beat the market, who are you actually trading against?
Each time you’re conducting a transaction, you’re entering into a trade against:
- Other amateur day traders
- Professional traders with bank, hedge fund capital behind them
- Institutional investors, such as investment banks and pension funds
- Mutual funds and Exchange Traded Funds
- Buy and hold long term investors
This is an incredibly diverse range of participants. At any given time, you won’t know who you’re actually trading with.
I find it more useful to consider the ‘market’ as an all-knowing and all-powerful entity, with an intelligence higher than my own. This helps to restrain any delusions that my trades will always be successful.
Is day trading suitable for beginners?
Even day traders have to start somewhere, therefore the concept of day trader beginners is as natural as seeing apprentices in any profession.
However this shouldn’t be taken to mean that day trading is suitable for novice investors in general.
In the following section, I’ll explain the drawbacks of day trading, which will set out quite clearly why investment novices should stay away from day trading until they consider themselves quite accomplished investors in their own right.
Is day trading a good idea?
In summary, I believe that for most individuals, day trading is not a good idea.
Further reading: The drawbacks of day trading
Many people do not have the education or experience to generate genuinely profitable trading ideas. This stuff is darn difficult.
Even if they have good trading ideas, a day trader also needs to have enough money to begin with to allow them to fully leverage their hunches, and provide a cash buffer to cover the cost of living.
And even if they have the intellect, and the upfront capital to finance themselves, do they have the patience and motivation to stick it out when the times are tough?
It’s not impossible – but it’s a high hurdle, and this is why I believe that only an elite minority of investors are blessed with the luck, personal capability and financial circumstances to be able to become a successful day trader.
Good investing books on day trading and other resources
I list the best investing books on my dedicated book shortlist, which you can use for inspiration, education and insights.
All leading financial voices share their love of investing titles. I firmly believe that beyond investing courses, books remain a great way to communicate complex ideas and a new mindset.