Historically, only large financial institutions, brokerages, and trading houses could actively trade in the stock market. With instant global news dissemination and low commissions, developments such as discount brokerages and online trading have leveled the playing—or should we say trading—field. It's never been easier for retail investors to trade like pros thanks to trading platforms like Robinhood and zero commissions.

Day trading is a lucrative career (as long as you do it properly). But it can be difficult for newbies, especially if they aren't fully prepared with a strategy. Even the most experienced day traders can lose money.

So, how does day trading work?

Day Trading Basics

Day trading is the practice of buying and selling a security on the same trading day. It occurs in all markets, but is most common in forex and stock markets. Day traders are typically well educated and well funded. For small price movements in highly liquid stocks or currencies, they use leverage and short-term trading strategies.

Day traders are tuned into short-term market events. News trading is a popular strategy. Scheduled announcements like economic data, corporate earnings, or interest rates are influenced by market psychology. Markets react when expectations are not met or exceeded, usually with large moves, which can help day traders.

Intraday trading strategies abound. Among these are:

• Scalping: This strategy seeks to profit from minor price changes throughout the day.
• Range trading: To determine buy and sell levels, range traders use support and resistance levels.
• News-based trading exploits the increased volatility around news events.
• High-frequency trading (HFT): The use of sophisticated algorithms to exploit small or short-term market inefficiencies.

A Disputed Practice

Day trading's profit potential is often debated on Wall Street. Scammers have enticed novices by promising huge returns in a short time. Sadly, the notion that trading is a get-rich-quick scheme persists. Some daytrade without knowledge. But some day traders succeed despite—or perhaps because of—the risks.

Day trading is frowned upon by many professional money managers. They claim that the reward rarely outweighs the risk. Those who day trade, however, claim there are profits to be made. Profitable day trading is possible, but it is risky and requires considerable skill. Moreover, economists and financial professionals agree that active trading strategies tend to underperform passive index strategies over time, especially when fees and taxes are factored in.

Day trading is not for everyone and is risky. It also requires a thorough understanding of how markets work and various short-term profit strategies. Though day traders' success stories often get a lot of media attention, keep in mind that most day traders are not wealthy: Many will fail, while others will barely survive. Also, while skill is important, bad luck can sink even the most experienced day trader.

Characteristics of a Day Trader

Experts in the field are typically well-established professional day traders.
They usually have extensive market knowledge. Here are some prerequisites for successful day trading.

Market knowledge and experience

Those who try to day-trade without understanding market fundamentals frequently lose. Day traders should be able to perform technical analysis and read charts. Charts can be misleading if not fully understood. Do your homework and know the ins and outs of the products you trade.

Enough capital

Day traders only use risk capital they can lose. This not only saves them money but also helps them trade without emotion. To profit from intraday price movements, a lot of capital is often required. Most day traders use high levels of leverage in margin accounts, and volatile market swings can trigger large margin calls on short notice.

Strategy

A trader needs a competitive advantage. Swing trading, arbitrage, and trading news are all common day trading strategies. They tweak these strategies until they consistently profit and limit losses.

Strategy Breakdown:

Type | Risk | Reward

Swing Trading | High | High
Arbitrage | Low | Medium
Trading News | Medium | Medium
Mergers/Acquisitions | Medium | High

Discipline

A profitable strategy is useless without discipline. Many day traders lose money because they don't meet their own criteria. “Plan the trade and trade the plan,” they say. Success requires discipline.

Day traders profit from market volatility. For a day trader, a stock's daily movement is appealing. This could be due to an earnings report, investor sentiment, or even general economic or company news.

Day traders also prefer highly liquid stocks because they can change positions without affecting the stock's price. Traders may buy a stock if the price rises. If the price falls, a trader may decide to sell short to profit.

A day trader wants to trade a stock that moves (a lot).

Day Trading for a Living

Professional day traders can be self-employed or employed by a larger institution.

Most day traders work for large firms like hedge funds and banks' proprietary trading desks. These traders benefit from direct counterparty lines, a trading desk, large capital and leverage, and expensive analytical software (among other advantages). By taking advantage of arbitrage and news events, these traders can profit from less risky day trades before individual traders react.

Individual traders often manage other people’s money or simply trade with their own. They rarely have access to a trading desk, but they frequently have strong ties to a brokerage (due to high commissions) and other resources. However, their limited scope prevents them from directly competing with institutional day traders. Not to mention more risks. Individuals typically day trade highly liquid stocks using technical analysis and swing trades, with some leverage. 

Day trading necessitates access to some of the most complex financial products and services. Day traders usually need:

Access to a trading desk

Traders who work for large institutions or manage large sums of money usually use this. The trading or dealing desk provides these traders with immediate order execution, which is critical during volatile market conditions. For example, when an acquisition is announced, day traders interested in merger arbitrage can place orders before the rest of the market.

News sources

The majority of day trading opportunities come from news, so being the first to know when something significant happens is critical. It has access to multiple leading newswires, constant news coverage, and software that continuously analyzes news sources for important stories.

Analytical tools

Most day traders rely on expensive trading software. Technical traders and swing traders rely on software more than news. This software's features include:

• Automatic pattern recognition: It can identify technical indicators like flags and channels, or more complex indicators like Elliott Wave patterns.

• Genetic and neural applications: These programs use neural networks and genetic algorithms to improve trading systems and make more accurate price predictions.

• Broker integration: Some of these apps even connect directly to the brokerage, allowing for instant and even automatic trade execution. This reduces trading emotion and improves execution times.

• Backtesting: This allows traders to look at past performance of a strategy to predict future performance. Remember that past results do not always predict future results.

Together, these tools give traders a competitive advantage. It's easy to see why inexperienced traders lose money without them. A day trader's earnings potential is also affected by the market in which they trade, their capital, and their time commitment.

Day Trading Risks

Day trading can be intimidating for the average investor due to the numerous risks involved. The SEC highlights the following risks of day trading:

Because day traders typically lose money in their first months of trading and many never make profits, they should only risk money they can afford to lose.
Trading is a full-time job that is stressful and costly: Observing dozens of ticker quotes and price fluctuations to spot market trends requires intense concentration. Day traders also spend a lot on commissions, training, and computers.
Day traders heavily rely on borrowing: Day-trading strategies rely on borrowed funds to make profits, which is why many day traders lose everything and end up in debt.
Avoid easy profit promises: Avoid “hot tips” and “expert advice” from day trading newsletters and websites, and be wary of day trading educational seminars and classes. 

Should You Day Trade?
As stated previously, day trading as a career can be difficult and demanding.

• First, you must be familiar with the trading world and know your risk tolerance, capital, and goals.
• Day trading also takes a lot of time. You'll need to put in a lot of time if you want to perfect your strategies and make money. Part-time or whenever isn't going to cut it. You must be fully committed.
• If you decide trading is for you, remember to start small. Concentrate on a few stocks rather than jumping into the market blindly. Enlarging your trading strategy can result in big losses.
• Finally, keep your cool and avoid trading emotionally. The more you can do that, the better. Keeping a level head allows you to stay focused and on track.
  If you follow these simple rules, you may be on your way to a successful day trading career.

Is Day Trading Illegal?

Day trading is not illegal or unethical, but it is risky. Because most day-trading strategies use margin accounts, day traders risk losing more than they invest and becoming heavily in debt.

How Can Arbitrage Be Used in Day Trading?

Arbitrage is the simultaneous purchase and sale of a security in multiple markets to profit from small price differences. Because arbitrage ensures that any deviation in an asset's price from its fair value is quickly corrected, arbitrage opportunities are rare.

Why Don’t Day Traders Hold Positions Overnight?

Day traders rarely hold overnight positions for several reasons: Overnight trades require more capital because most brokers require higher margin; stocks can gap up or down on overnight news, causing big trading losses; and holding a losing position overnight in the hope of recovering some or all of the losses may be against the trader's core day-trading philosophy.

What Are Day Trader Margin Requirements?

Regulation D requires that a pattern day trader client of a broker-dealer maintain at all times $25,000 in equity in their account.

How Much Buying Power Does Day Trading Have?

Buying power is the total amount of funds an investor has available to trade securities. FINRA rules allow a pattern day trader to trade up to four times their maintenance margin excess as of the previous day's close.

The Verdict

Although controversial, day trading can be a profitable strategy. Day traders, both institutional and retail, keep the markets efficient and liquid. Though day trading is still popular among novice traders, it should be left to those with the necessary skills and resources.

As you know, I like to turn my intuition into decision rules (principles) that can be back-tested and automated to create a portfolio of alpha bets. I use one for bubbles. Having seen many bubbles in my 50+ years of investing, I described what makes a bubble and how to identify them in markets—not just stocks.

A bubble market has a high degree of the following:

1. High prices compared to traditional values (e.g., by taking the present value of their cash flows for the duration of the asset and comparing it with their interest rates).
2. Conditons incompatible with long-term growth (e.g., extrapolating past revenue and earnings growth rates late in the cycle).
3. Many new and inexperienced buyers were drawn in by the perceived hot market.
4. Broad bullish sentiment.
5. Debt financing a large portion of purchases.
6. Lots of forward and speculative purchases to profit from price rises (e.g., inventories that are more than needed, contracted forward purchases, etc.).

I use these criteria to assess all markets for bubbles. I have periodically shown you these for stocks and the stock market.

What Was Shown in January Versus Now

I will first describe the picture in words, then show it in charts, and compare it to the last update in January.

As of January, the bubble indicator showed that a) the US equity market was in a moderate bubble, but not an extreme one (ie., 70 percent of way toward the highest bubble, which occurred in the late 1990s and late 1920s), and b) the emerging tech companies (ie. As well, the unprecedented flood of liquidity post-COVID financed other bubbly behavior (e.g. SPACs, IPO boom, big pickup in options activity), making things bubbly. I showed which stocks were in bubbles and created an index of those stocks, which I call “bubble stocks.”

Those bubble stocks have popped. They fell by a third last year, while the S&P 500 remained flat. In light of these and other market developments, it is not necessarily true that now is a good time to buy emerging tech stocks.

The fact that they aren't at a bubble extreme doesn't mean they are safe or that it's a good time to get long. Our metrics still show that US stocks are overvalued. Once popped, bubbles tend to overcorrect to the downside rather than settle at “normal” prices.

The following charts paint the picture. The first shows the US equity market bubble gauge/indicator going back to 1900, currently at the 40% percentile. The charts also zoom in on the gauge in recent years, as well as the late 1920s and late 1990s bubbles (during both of these cases the gauge reached 100 percent ).

The chart below depicts the average bubble gauge for the most bubbly companies in 2020. Those readings are down significantly.

The charts below compare the performance of a basket of emerging tech bubble stocks to the S&P 500. Prices have fallen noticeably, giving up most of their post-COVID gains.

The following charts show the price action of the bubble slice today and in the 1920s and 1990s. These charts show the same market dynamics and two key indicators. These are just two examples of how a lot of debt financing stock ownership coupled with a tightening typically leads to a bubble popping.

Everything driving the bubbles in this market segment is classic—the same drivers that drove the 1920s bubble and the 1990s bubble. For instance, in the last couple months, it was how tightening can act to prick the bubble. Review this case study of the 1920s stock bubble (starting on page 49) from my book Principles for Navigating Big Debt Crises to grasp these dynamics.

The following charts show the components of the US stock market bubble gauge. Since this is a proprietary indicator, I will only show you some of the sub-aggregate readings and some indicators.

Each of these six influences is measured using a number of stats. This is how I approach the stock market. These gauges are combined into aggregate indices by security and then for the market as a whole. The table below shows the current readings of these US equity market indicators. It compares current conditions for US equities to historical conditions. These readings suggest that we’re out of a bubble.

1. How High Are Prices Relatively?

This price gauge for US equities is currently around the 50th percentile.

2. Is price reduction unsustainable?

This measure calculates the earnings growth rate required to outperform bonds. This is calculated by adding up the readings of individual securities. This indicator is currently near the 60th percentile for the overall market, higher than some of our other readings. Profit growth discounted in stocks remains high.

Even more so in the US software sector. Analysts' earnings growth expectations for this sector have slowed, but remain high historically. P/Es have reversed COVID gains but remain high historical.

3. How many new buyers (i.e., non-existing buyers) entered the market?

Expansion of new entrants is often indicative of a bubble. According to historical accounts, this was true in the 1990s equity bubble and the 1929 bubble (though our data for this and other gauges doesn't go back that far). A flood of new retail investors into popular stocks, which by other measures appeared to be in a bubble, pushed this gauge above the 90% mark in 2020. The pace of retail activity in the markets has recently slowed to pre-COVID levels.

4. How Broadly Bullish Is Sentiment?

The more people who have invested, the less resources they have to keep investing, and the more likely they are to sell. Market sentiment is now significantly negative.

5. Are Purchases Being Financed by High Leverage?

Leveraged purchases weaken the buying foundation and expose it to forced selling in a downturn. The leverage gauge, which considers option positions as a form of leverage, is now around the 50% mark.

6. To What Extent Have Buyers Made Exceptionally Extended Forward Purchases?

Looking at future purchases can help assess whether expectations have become overly optimistic. This indicator is particularly useful in commodity and real estate markets, where forward purchases are most obvious. In the equity markets, I look at indicators like capital expenditure, or how much businesses (and governments) invest in infrastructure, factories, etc. It reflects whether businesses are projecting future demand growth. Like other gauges, this one is at the 40th percentile.