Day trading is a risky method that is sometimes sold as a get-rich-quick approach to the stock market. While educated traders may be able to turn day trading into a successful career, amateurs can lose money quickly.
What is day trading?
Day traders buy and sell stocks throughout the day with the hopes of cashing in on small fluctuations in the price of highly liquid stocks or indexes. As with investing, the ideal situation involves buying low and selling high, but in this case the time frame is shortened from years to hours. Day traders want to make money by successfully completing numerous sales in the same day.
So, if someone buys 1,000 shares and then sees a half-hour later that the price of that stock rose, he or she may decide to sell. From the sale, the trader makes the difference -- whatever that may be -- minus commission.
The most touted pro of day trading is that it can earn you serious money, provided that you can afford to take the risk, understand the inner workings of the marketplace and have a well thought out strategy. You can increase your returns through leverage (money that you borrow to make more money). If you find work with a large institution, you may gain access to expensive software and a direct line to the dealing desk, along with other perks and resources.
Day traders play a role in the overall marketplace, thanks to arbitrage -- a common day trading strategy that involves identifying market discrepancies. An asset's price should be the same across the board, but if this is not the case and you see the difference fast enough, you can sell the higher-priced asset and buy the lower priced one.
The bottom line is that day trading carries a high risk. There is never a guarantee that you will make money. In fact, according to the U.S. Securities and Exchange Commission, "day traders typically suffer severe financial losses in their first few months of trading."
Day trading is expensive. You need software and the right computers to spot the price variations and access the necessary financial information. Because you may acquire capital losses and gains as a day trader, taxation can become a nightmare. Short-term capital gains, which are places on assets held for less than a year, are taxed at your income tax rate. Visit the IRS website for more information.
You need to have risk capital, or money you can "afford" to lose, to protect yourself. The SEC also requires that day traders have a minimum of $25,000 in their account at the end of the trading day if they plan on making at least four round-trip day trades over a five-day period.
Another potentially negative aspect of day trading is that your success may be closely tied to the nature of the current market environment.
"When the market is in a churning period in which there is not significant upward or downward movement, then daily traders tend to lose money, especially after consideration of the commission costs and the bid-ask spread that they are frequently trading into," says Walt Woerheide, dean and professor of investments at The American College in Bryn Mawr, Penn.
Day trading also comes with a steep learning curve and the chance you can fail. It is a high-pressure, stressful job that takes discipline and strategy, and you can't let your emotions influence your trading decisions.