Author: Ifrim Andrei Mihail
Date of publication: 16/2/2022
Interest in financial markets has risen considerably over the last 2 years and the pandemic has contributed a lot to it as many people stuck at home either looked for or involuntarily found something about trading. The idea of potentially making money through a pc, mobile phone or tablet from anywhere is surely appealing but one should keep in mind that it is something which requires education, experience and discipline in order to be successful. This article is going to describe and analyze a type of trading which a lot of people are interested in: day trading.
In financial markets there are different types of trading: investing, swing trading and day trading.
- Investing involves opening a position and closing it after several months or years (as the noun tells, it is about investing on assets for the long term without stressing much about short-term price movements);
- Swing trading has as fundamental characteristic opening and closing a position within a few days or weeks, trying to profit from price swings while letting the asset “breath” and do its thing. Swing traders primarily use technical analysis to look for trading opportunities and they may also utilize fundamental analysis;
- Day trading requires opening and closing a position within the same day, therefore holding no shares overnight. This is seen as a rule day traders have to respect in order not to carry risk from one session to another since the next day the asset may gap up or down significantly, thus implying a risk of sudden large losses which would heavily affect the trader’s account balance.
A day trader executes a relatively large volume of short (betting that the price will fall) and long (betting that the price will rise) trades to capitalize on intraday market price action. Moreover, day traders can also use leverage to amplify returns, which can also amplify losses.
By trading on margin and using leverage, in order to open a position one needs to use only a portion of the value (for example, under a x5 leverage, in order to open a position worth $ 5000 you would only need to use $ 1000 from your account).
Compared to the other 2 ways of trading, day trading is much more challenging and requires having an edge/strategy, experience and discipline in order to be a profitable business. Having an edge implies that over time the trader will make money but that will not be enough to be profitable if the trader does not treat it as a business (having also expenses/losses). That’s why discipline plays a key role in the success of a day trader: one can have very good strategies but if that is not combined with following strict rules he/she will not succeed since a few losing trades with large losses can wipe out a lot of previous profitable trades. Many day traders lose money because they fail to make trades that meet their own criteria: one should “plan the trade and trade the plan”.
For example, let’s say you have a strategy which is right 70% of the time and when it plays out you make 2% profit on average, while when it does not you lose 1% on average. Now, let’s imagine that once you do not stick to your rules, you do not set a stop loss and instead you hold a losing position in the hope that the market will reverse in the direction of your trade and it happens that the loss keeps getting larger and larger until you can take no more and you close your position at a 14% loss (instead of a 1% loss that your strategy suggests). Due to lack of discipline in that trade, to recover that loss it will take several successive winners, while if you had respected your plan and set a stop loss of 1%, a winning trade of 2% would have more than recovered that.
DAY TRADING STOCKS
Professional and experienced day traders usually trade the first 2 hours of market open since that’s the period of the day when there is the highest volume and volatility, which they try to profit from by holding a position for some minutes or even seconds (‘scalping’), but often also for some hours (‘intra-day trading’).
The preparation starts in pre-market, when traders look for stocks that have catalysts (earning reports or news) and/or large pre-market volume, high relative trading volume. That is because they look for stocks which will move significantly in one direction on that day, so that they can take advantage of.
In the case of a stock releasing an earnings report, a day trader considers whether it beat analysts expectations/forecasts, whether the guidance is good or not (showing growth and better than analysts’ forecasts or not) and then he/she analyzes the stock chart.
- An example of where you can find the list of stocks releasing earning reports on the day is https://www.investing.com/earnings-calendar/
- An example of where you can find the most active stocks in the pre-market session is https://www.investing.com/equities/pre-market
THE PREPARATION PROCESS BEFORE MARKET OPEN
- Look on a stock screener to find the most active stocks and stocks that have gapped up or down significantly in the pre-market
- Look for earning reports on earnings calendar or for any other type of catalyst
- Create a watchlist of stocks you want to analyze and prepare a trade plan on for market open
- Conduct technical analysis on each stock and see whether it offers good trading opportunities
- Create a plan based on a strategy (including entry, take profit and stop loss prices) that has proven to be successful over time (an edge)
- Trade the plan and be disciplined (if the trade goes against your plan, take your pre-defined loss and move on. Tomorrow is another day and the market will offer other opportunities)
DATA AND INDICATORS USEFUL IN TECHNICAL ANALYSIS FOR DAY TRADING
When analyzing a stock, a day trader draws and considers several things:
- Key price levels by looking where the price got rejected (resistance) and where it bounced back up (support). For that, it is necessary to start looking at the chart from higher timeframes to lower timeframes (daily, then 4h, 2h, 30 min…) in order to see whether the stock is in an uptrend or downtrend and spot strong key levels;
- Exponential Moving Average (EMA) which is a type of Moving Average that places a greater weight and significance on the most recent data points. EMAs are useful to define an uptrend or a downtrend and whether the stock price reacted at those levels (for example, when on an uptrend the stock price retraces a bit toward an EMA and it bounces off it continuing upward, it can be said that the EMA acted as a dynamic support);
- Volume Weighted Average Price (a line showing the average price the stock has traded, over a period, based on volume and price) is used to establish the trend and make decisions on entry/exit levels. For example, when the price is close to and slightly above the VWAP, a trader may go long expecting that the line will act as dynamic support;
- Relative Strength Index (RSI) is a momentum indicator used in technical analysis as it measures the magnitude of recent price changes to indicate bullish or bearish price momentum and whether the stock is ‘overbought’ (usually considered as such when the RSI is above 70) or oversold (usually when the RSI is below 30);
- The free float of the stock, that is, the number of outstanding shares available for trading in the open market. This information is useful to define whether a stock is a small-cap, a medium or high cap one since each type moves differently; a small-cap stock (or penny stock if its price is equal or lower than 5$) is much more volatile than the others when there is high relative volume being traded as there are not many shares available and a large buy or sell order can heavily influence the price change. In this case the trader has to be more cautious as higher volatility carries more risk and in the case of small-cap stock a stop-loss order may not get filled at the specified price if it moves too fast
- The short interest represents the percentage of the free float that has been sold short and still not bought back/covered and it is an indicator of market sentiment. This information is useful because when a stock has very bullish news and the short interest is high, the price can experience very high volatility to the upside when short sellers close their position therefore contributing to the buying pressure.
- Average daily volume traded over a certain period (for example over the past 3 months) in order to compare it to the current volume since day traders prefer to trade stocks with high relative trading volume on the day
- Average True Range (ATR) is a market volatility indicator and it is typically derived from the 14-day simple moving average of a series of true range. Traders prefer higher values of ATR as it increases the probability of the stock to move more in a certain direction, which means more profit potential;
- The high, low, open and close prices of the previous session as they can be used as additional key levels (they can act as support/resistance);
- Last, but not least, the overall market sentiment (which can be determined by looking at how the Dow Jones 30 and Nasdaq 100 indices are performing) since it heavily affects the direction of the stocks (for example, if a stock has positive news but the market sentiment is bearish, its price will not increase as much as it should and it may even have a red day).
LEVEL 2 MARKET DATA: AN IMPORTANT TOOL FOR DAY TRADING
Level 2 Market Data is very important for day traders because it allows to see buy (bid) and sell (ask) limit orders in the order book, market depth and times & sales. The order book is helpful because by seeing at each price the amount of shares from orders that are waiting to get filled, together with seeing transactions on real time on the time & sales, a trader can better forecast the behavior of the market and identify support and resistance levels (for example, the last traded price is $ 30.10, we see that on the bid side of the order book at $ 30.07 there are 500 shares, at $ 30.05 there are 1000 shares and at $ 30.00 there are 20,000 shares; we can say that at $ 30.00 there is a great bullish interest which can keep the price from dropping below [support]).
When investing, swing trading or day trading, one should always consider it as a business. Here is where money management and discipline come into play: given that no one knows with certainty what the market will do next (there is nothing sure in the market), a trader should have a mindset which accepts losses (and takes them when they are still small), should not get emotionally affected by a losing trade since the focus should be on the long term, sticking to a strategy with a positive expectancy over a larger group of trades.
In order to have good money management, the majority of traders risk no more than 1-2% of their account balance on a single trade. By knowing how much of your account balance you want to risk and having a plan with entry, target and stop loss prices, you can determine how many shares to open a position with in this way:
you determine the amount that you are willing to risk on a trade (for example, if your account balance is $ 5000 and you want to risk 2% of it on a trade, the amount that you would determine is $ 100);
you calculate the amount of the loss per share that you would incur in case the market goes against your position (equal to the distance between the entry price level and the stop loss level);
you calculate the amount of shares your position should have by dividing the amount that you are willing to risk (1) by the amount of the loss per share that you would incur in case of a losing trade (2).
One should analyse and make decisions also after the position is opened. That is, if the market goes in your favor, you may take some profits by closing a portion of your position and then you could even move the stop loss if you want your risk to be smaller from that point on.
Being able to make changes during a trade is important because it allows you to secure some profits and reduce your risk. For example, let’s say that you buy 400 shares of a stock at $ 30, your initial stop loss is at $ 29.50 and your ultimate take profit target is $ 32. The market moves in your favor and when the stock reaches $ 31 you close 30% of the position and move the stop loss to beak-even ($ 30) for the remaining part. By doing that for this trade you have some guaranteed profits and you ensure that it will be profitable until the end.
In conclusion, success in day trading requires one to be educated, to use several tools, to have strategies, rules and to be disciplined. One of the key principles is being objective, not relying on emotions, cutting losses quickly when the trade goes against the initial plan and maximizing profits when the trade is proving to be a winner.