Day Trading Stocks Profitably

With all the publicity that day trading has gotten recently, I felt it would be particularly timely to examine this new style of trading that has emerged.

The basic facts are the following:


  1. Day trading has become popular because of low online brokerage fees ($8-20 per trade);
  2. Day trading has become more popular because of trading networks like SOES
  3. The steady increase in stock prices, especially Internet stocks, has caught the attention of many investors and traders.

While this environment has created a great deal of enthusiasm for the potential rewards of day trading, there also are risks to consider. In this article I’ll look at both sides of the day trading coin.

Rewards

Reduced overnight risk. The fact that all trades are closed out at the end of the trading day eliminates the chance of being exposed to negative news from the close of one session to the open of the next.

For example, if you’re long Yahoo (YHOO) and they announce lower-than-expected earnings, the stock would open up much lower than where it closed the day before. Some will disagree with this because of the availability of after-hours trading. But realistically, when the news is announced, the stock will trade down very fast and the trader will most likely experience a tremendous amount of slippage anyway.

Allocating capital to dynamic stocks. Day traders have the chance everyday to trade stocks that are moving. This is important because the list of fast-moving stocks tends to be different everyday. Volatility is key to day traders because they require the stocks they trade to move before the market closes. If there is no volatility, slippage and commissions will most likely produce a loss.

Leverage opportunities.
Some brokerage firms that specialize in day trading give their clients the ability to leverage more than the standard 50% margin ratio. (By leverage of 50%, I mean that typically, the trader must put down at least half the capital to carry his position, thus creating a 2:1 leverage ratio–one dollar controls two dollars worth of stock.)

When a trader can use more leverage than this, he has an advantage because he can increase his position size without increasing his trading capital requirement. As a result. the chance for greater profits is magnified as the positions sizes are increased. In addition, because most online brokers charge a flat fee regardless of the number of shares traded, the trader doesn’t have to pay increased commissions. In essence, what transpires is increased position size (and greater chance of profit) and no increase in trading cost. This can be very significant for traders who make a many trades per day.

Risks

Mental fatigue. The very fact that day trading requires you to monitor your positions constantly can be very difficult. Traders usually know how much they are winning or losing with every price change in their position. Over long periods of time this has the tendency to “grind down” your mental alertness, especially during losing periods.

Compare this to the position trader who has the luxury of taking a mental break and doing something else for a while, clearing his mind and letting his emotions settle. Over time, there can be a dramatic difference between the mental outlook of these two types of traders. A good illustrative example is the foreign exchange traders who must look at their screens all day as they try to day trade. The shelf life of one of these traders is relatively short; burnout tends to set it with the majority of them because they can no longer cope with the mental fatigue of their jobs.

Equipment failure Because most day traders require very fast executions, this magnifies the negative effect of execution failure. If you are using an online broker, you’ll be extremely sensitive to the site working at optimum capacity. If the site goes down, you could take unnecessary losses. If you’re using a direct system to the exchange, you still have the same risk.

Quote system failure is another problem. Quote systems can and do stop working for hours or days at a time. This could be very costly for a trader who thinks he has a profit on his position, only to discover the position has gone against him in the last 20 minutes while his quotes were still showing him a profit!

Compare this to the position trader who may not be affected at all by a failure since there is less of a chance that he will need to trade at the same time his equipment fails. Most people will point out that these failures are relatively rare; they are absolutely right. The real problem is that when the markets are moving the most (when day traders have the greatest profit opportunity) is unfortunately the same time such failures tend to happen. This happens because too many traders are using the system at the same time and the system overloads.

Quality of executions Most online brokers send their client orders directly to the exchange where buy order are executed a the current offer and vice versa for sell orders. The day trader is never given the chance to try to trade between the bid and offer. Further, some online brokers sell their order flow to other market makers so the order is passed between two brokers before it finally gets executed. This can cause delays in fast market conditions.

Solutions

Now that we have examined the pros and cons of day trading, we will examine some strategies that try to address these issues and still give the day trader a good chance of profitability.

Quotes. Being a day trader doesn’t mean you can’t use daily data to make your trading decisions. Using daily data has the following advantages:


  1. Quote outages are not as detrimental. If you don’t need every price change during the day to make decisions, you won’t be as sensitive to the inevitable outages. Even the best quote services experience outages which could cause losses or deviations from a trading system. On the other hand, if your are using daily data, you probably will already know where you want to buy at the beginning of the day and you can place the order and move on to something else.

  2. Daily data is a fraction of the cost of real-time data. This can reduce overhead by thousands of dollars per year.

  3. Strategy improvements. My research has shown there tends to be a lot of random price movement during the day in stocks. This has major implications for day traders who input intra-day data into their systems.

    What does random price movement actually mean? It means that intra-day up moves in a stock have a tendency to reverse themselves more often in the day. This makes analyzing these moves with systems more difficult and thus harder to trade. If you examine the same stock on a daily basis, you will notice there is more follow-through on breakouts. This is because the fundamentals have more time to reflect themselves in prices, which tends to create trends that are tradable.

    There are many reasons for increased random price movement intra-day, but I will name only the biggest:


    1. Program trading: The most popular stocks for day traders are sometimes the same stocks that are part of baskets that program traders use. They buy or sell these baskets of stocks for arbitrage trades between stocks and index futures or stock options. These trades are executed by major Wall Street investment banks for their own accounts or clients accounts.

      Usually these trades are very large and have nothing to do with the current trend of an individual stock. Rather it has to do with the price relationship between the premiums on index futures or stock options and the underlying stocks. It is a completely different strategy, but because the size of the trades are so big, a trader is at a disadvantage ignoring this. In essence, if a stock breaks out, it is significant to the day trader but not to the program trader.

    2. Fundamentals driving stock prices: A company’s fundamental business prospects are what ultimately determine its stock price. The key word here is ultimately. Ultimately can take days, weeks, or longer. Therefore the day trader who is looking at stocks in a daily perspective is using this fact more to his advantage than the day trader who is using five-minute bars to determine his buy sell decisions.

Scanning ability

If day traders only want to be in stocks that are moving, then why not only trade when there is a breakout? To illustrate this point we have included some charts of a simple breakout system. The day trader could apply this system to hundreds of stocks but only trade the ones which are moving. By doing this he can allocate his time more wisely and avoid stocks that are not moving, which is one of the day traders biggest impediments to being profitable.

Examples. We have applied a simple volatility expansion system on two stocks Amazon.com (AMZN) and America Online (AOL), which were chosen for their volatility and their liquidity–where the day trader wants to be. Notice these are for long trades only.

The rules for the system are the following:


  1. Take the average true range for the last four days;
  2. Calculate the average of yesterday’s close and today’s open;
  3. Add the average true range plus 5% to the average of the open and yesterday’s close;
  4. Place a buy stop for listed stocks or an alarm for NASDAQ stocks to buy at this price.



Figure 1. Amazon.com (AMZN), daily. Source: Omega Research.



Figure 1. America Online (AOL), daily. Source: Omega Research.

As you can see, trading AMZN and AOL with this approach produced some decent results. It would have kept you out of the downtrends while keeping you in the uptrends.

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