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How Day Trading Works

Popular Markets for Day Trading
Japanese businessmen pass a foreign exchange rate chart in downtown Tokyo.
Japanese businessmen pass a foreign exchange rate chart in downtown Tokyo.
Yoshikazu Tsuno/Getty Images

An important part of a day trader's business plan is picking a market or markets in which to play. Most traders specialize by concentrating their efforts in one or two markets. This enables them to become intimately familiar with the subtleties and idiosyncrasies of the market so they can make better decisions. Popular markets for day traders include financial futures, foreign exchange (or Forex) and the stock market. Let's look at each of these in more detail.

A futures contract is an agreement between a buyer and seller to make a specific trade at a specified future date and price. Traditional futures contracts involve commodities, such as foods, fats and oils, fibers and textiles, metals, precious metals and miscellaneous materials such as rubber and steer hides. Investors use futures to offset uncertainty and risk. How do futures work?

Suppose you're a corn farmer with a few months to go until harvest time. If you could sell your crop today at the current price of $5 per bushel, you could make a profit. But if the price drops to $4 per bushel before you're ready, you could be wiped out. So you enter into a futures contract with a buyer (perhaps a cereal manufacturer), agreeing to sell a specific amount of corn at a future date for a price that seems fair -- like $4.75 per bushel. If the crop's price drops to $4 per bushel, you'll still lose money, but you'll make a profit off the futures contract. And if prices stay at $5 per bushel, your futures contract will result in a loss, but you can offset the loss with the profitable sale of your cash crop.

Financial futures work on the same principles, except they are based on changes in such market indexes as the S&P 500 or the Dow Jones Industrial Average. A day trader working with financial futures is basically betting that a specific index will achieve a certain level at a certain date in the future.

Another market is Forex. Forex involves trading in international currencies to profit from changes in the exchange rates. It's one of the most common markets for day traders because it's a large market with a lot of opportunities, and it's open for trading all day, six days a week. Because Forex price changes are small, traders must use leverage to make any significant profits.

The stock market is still one of the most common markets for day traders. Many traders focus primarily on stocks listed on the NASDAQ exchange. With approximately 3,200 companies, NASDAQ lists more companies than the New York Stock Exchange or the American Stock Exchange and trades more shares per day. Many NASDAQ companies are small, speculative and focused on technology products or services. This makes the market extremely volatile and a great place for day traders to find trading opportunities.

Actually, volatility is one of the characteristics day traders look for in any of the markets described above. Volatility measures how much the price of a security will vary over time. The price of a highly volatile security fluctuates a lot, making the security a prime candidate for day trading because it's the intra-day price movements that allow profits to be made.

Liquidity is another factor in the favorite markets of day traders. Day traders like liquidity, which refers to the ability to buy and sell an asset without affecting price levels. Such assets experience a high level of trading activity, meaning they trade easily, several times a day.

What trading strategies do day traders use? Read on to find out.