How Day Trading Works

First, let's be clear about what day trading isn't. It's not investing, which is the process of buying a stake in an asset that will hopefully build a profit over the long term. How long is subjective, but investors generally hold assets for years, even decades. And they're usually concerned with the businesses they invest in. They look for companies that make solid profits, pay off debts in a timely manner, have a strong pipeline of products and avoid litigation.

Day trading, on the other hand, involves buying and selling securities within the same day. Day traders often use borrowed money to take advantage of small price movements in highly liquid stocks or indexes. In general, they follow the same wisdom as longer-term investors: They try to buy low and sell high -- they just do it in a very compressed window of time.

It might work something like this. Let's say a day trader buys 1,000 shares of a certain stock at 10:00 a.m. At 10:15, as the price begins to rise, he or she then sells it. If the stock is up by ½ ($0.50) when he or she sells, the day trader makes $500, minus a commission. If our trader is using Scottrade, a popular online trading platform, the commission for stock transactions can range from $7 to $27, giving our trader a net profit in the range of $493 to $473. Of course, we have to take taxes into consideration. When a person sells an investment he or she has owned for less than a year, the profit is taxed at the person's personal gains rate, which can be as high as 35 percent. Long-term capital gains, by contrast, aren't taxed at a higher rate than 20 percent. Clearly, tax planning is an essential element of day trading.

If our trader's profit seems like small potatoes, remember that day traders don't make one or two trades a day -- they may make 25 to 30. Thus, they multiply their profits by increasing the volume of trades. To limit their risks, day traders generally won't own stock overnight because prices can change radically from one day to the next. News events and corporate announcements often drive this market volatility, so traders must be available and ready to respond at a moment's notice. Unlike investors, who may wait until logic prevails or for additional information becomes available, day traders move quickly, making decisions in minutes, even seconds.

In between the two extremes -- investing for years and trading in seconds -- exist other investment horizons and other types of trading. Swing trading refers to holding a stake in a stock or commodity for several days. Position trading refers to holding a stake in a stock or commodity for several weeks or months. The diagram above shows how the timing of these various activities varies. They all carry a certain amount of risk, but day trading is probably the riskiest and the most controversial. When we look at the history of day trading next, we'll learn where its infamous reputation came from.

Day trading is a relatively recent phenomenon -- one made possible by several events and rulings throughout the past century or so. Let's take a look at the critical events that had an impact on the evolution of day trading.

1867: Following the invention of the telegraph, the first ticker tape was developed, making it easy to communicate information about transactions occurring on the exchange floor with brokers. Most brokers who traded at the New York Stock Exchange kept an office nearby to ensure they were getting a steady supply of tape and the most current information.

1928: At the height of one of the stock market's most notable bull markets (a market in which stocks are increasing), traders didn't have direct access to the market. They had to place orders through a broker, who used information collected off the ticker tape.

1971: The National Association of Securities Dealers (NASD) formed its own electronic communication network (ECN): the National Association of Securities Dealers Automated Quotation System (NASDAQ). An ECN is any computer system that facilitates financial products trades outside of stock exchanges.

1975: The Securities and Exchange Commission (SEC) established rules that abolished fixed commissions. For the first time in 180 years, trading fees were set by market competition. Many firms, such as Charles Schwab, began allowing customers to trade stock at discounted commission rates. This marked the beginning of the discount brokerage era.

1987: Because most trades were conducted over the phone, firms buying and selling NASDAQ securities had an easy way to avoid small investors trying to call in a trade during the October stock market crash -- they simply didn't answer their phones. In response, the SEC introduced the Small Order Entry System (SOES), which gave orders of 1,000 shares or less a priority over larger orders.

1997: The dot-com craze fueled speculation in technology stocks as another notable bull market charged ahead. At the same time, Internet access was becoming widely available. Several online trading companies, such as E-Trade, launched their Web sites and helped stir the pot further with much-publicized IPOs. Suddenly, small traders had direct access to price quotes and trading activities, which leveled the playing field for everyone. Some even argued that the market favored small traders, who could take advantage of the SOES. Unfortunately, these traders also earned a tarnished reputation as SOES bandits.

1999: Day trading received more and more public attention. In testimony before Congress, Arthur Levitt, Chairman of the SEC, estimated the number of day traders to be around 7,000. His estimate of the number of investors using the Internet for brokerage services: 5 million. The negative effects of day trading also made headlines. Mark Barton went on a shooting spree in an Atlanta day trading office, convincing many people that day trading was so stressful it could drive a man to commit murder. Just two weeks after the shooting, the North American Securities Administrators Association released a report stating that seven out of 10 of day traders lose everything.

2000: The SOES was changed to eliminate the advantages for day traders, but the biggest blow came in the form of another stock market collapse. When the dot-com bubble burst, many of the day-trading opportunists, either bankrupted or frightened away, sought new careers.

2008: The lawless, frontier feeling of day trading is long gone, as are most of the get-rich-quick hopefuls. In its place are professional day traders who pursue their work with the same diligence and care as any other professional.

In the next section, we'll look at what it takes to be a day trader.

In theory, anyone could become a Formula One racecar driver, but in reality, very few people possess the right skills or temperament for such a demanding sport. The same is true for day trading. Day traders must possess certain personality traits and have access to certain resources if they're to be successful.

These are the essentials.

People who attempt to trade without these attributes or resources are very likely to fail, and many do. Those that succeed encounter a severe learning curve. Once they gain experience, traders often take up day trading professionally, either as part of a larger institution or as lone rangers. Institutional day traders work shoulder-to-shoulder with other traders in large, computer-laden trading rooms. Individual day traders work from their homes or offices.

Either way, it's a full-time occupation. Part-time day trading is possible, but difficult. Those who adopt a part-time approach still treat their trading as a business. They set a schedule -- and follow it religiously. This discipline distinguishes them from hobbyists or those who experiment with day trading as a form of gambling. In fact, many compulsive gamblers have lost significant sums of money attempting to day trade, compelling Gamblers Anonymous to open a day trading division.

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.

Day traders employ certain techniques to increase their profits. Two of the most important are leverage and selling short. We've discussed leverage several times throughout the article, but it's worth mentioning again. If you'll recall, leverage is the process of borrowing money to make more money.

Let's say a particular trade results in a 10 percent return. If you have $50,000 in your account, then your return will be $5,000. But if you borrow another $50,000 and add it to your account, then your return doubles -- you make $10,000. Leverage enables you to increase the dollars returned to you without increasing the performance of the trade.

Where do day traders find this money? They generally borrow it from their brokerage firms, using a special account known as a margin account. The margin account is different from a trader's cash account and requires an initial investment of at least $2,000. Once the margin account is opened, a trader can borrow up to 50 percent of the purchase price of a stock. This is also known as buying on margin.

Another borrowing strategy is selling short. A day trader who sells short borrows a security and then sells it in the hopes of repaying the loan by buying back cheaper shares later on. In this case, the trader looks for a security that is going down in price (as opposed to the more common practice of buying low and selling high). Once he identifies such a security, the trader:

Both leverage and selling short carry certain risks, and both can result in a day trader losing his assets and being asked to pay back those he borrowed. One of the biggest dangers is the margin call. A margin call may be issued when the value of a trader's margin account falls below a preset limit known as the maintenance margin. To satisfy the margin call, a trader must deposit more money into his account. If he can't do that, the broker will start selling the trader's securities until the maintenance margin is once again attained. Under most margin agreements, a firm can sell a trader's securities without waiting for him to meet the margin call. He may not even be able to control which securities are sold.

To reduce the risks associated with trading on margin, day traders use stop-losses. A stop loss order is an order to sell a security at the market price as soon as it hits a predetermined level. The advantage of a stop order is that a trader doesn't have to obsess over a stock's performance, knowing he has a measure of protection. The disadvantage is that the stop price could be triggered by a short-term fluctuation in a stock's price. Still, a stop order is an important tool for day traders, as is a "mental" stop-loss: a maximum amount that a trader is willing to lose in a day.

So do the risks of day trading outweigh the rewards? Find out in the next section.

Although the stock market collapse of 2000 ended the careers of many day traders, the profession is still alive and well. According to the Occupational Outlook Handbook, which is produced by the U.S. Department of Labor, there were 320,000 securities, commodities and financial services agents in 2006. This number includes day traders, but it also includes stockbrokers, floor brokers, investment bankers and financial service advisors. We can't tell for certain how many day traders are included in the grand total, but we can make some assumptions for the sake of an example. If we assume for a moment that full-time day traders only represent five to 10 percent of this population, that amounts to 16,000 to 32,000 individuals who call themselves day traders. Amateurs and part-timers may number in the millions.

A few of these individuals actually make a lot of money. But can you? Before you decide, let's review some important facts about day trading covered in this article:

If you're not intimidated by these warnings, then day trading might be right you. If you are wary, it might be best to stick with more traditional investing strategies, which offer more balanced risks and rewards.

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