Day Trading For Dummies
This Cheat Sheet for day trading covers the equipment you need to day trade, swing trade, or invest from home. It explains terms traders use, covers technical analysis, and discusses performance evaluation.
Equipment, Software, and Brokerage Accounts a Day Trader Needs
To be successful as a day trader, you need equipment that lets you access and act on trading information quickly, software that lets you keep track of your trades and analyze your performance, and a brokerage account through which you can execute your trades. This list gives you guidance on what to look for when selecting each of these things:
A PC with a good monitor: Most personal computers sold today have the processing power to handle day trading. Because you’ll be spending a lot of time in front of your computer, do yourself a favor and get at least one large flat screen monitor that enables you to have at least two windows open at one time.
A second PC: No matter which brand of computer you buy, you’re subject to mechanical or software glitches that can shut you down. For this reason, have a duplicate of your system on a laptop or second PC so that you can switch over quickly if you need to.
High-speed Internet access: You need a fast, reliable connection of at least 4 megabits per second.
Spreadsheet software: Spreadsheets help you track performance and analyze returns. Although other software packages can work, Excel is the standard. So if you still haven’t figured out how to use Microsoft Excel, you now need to.
An online brokerage account: Several brokerage firms specialize in the needs of high-volume traders. They offer online access, real-time quotes, backtesting and other analytical services, and low commission to those who make many trades.
Important Day Trading Terms
Day trading, like any other business, has its own special language — the vocabulary of buying and selling financial instruments. During your trading career, you may come across these terms:
Arbitrage: Arbitrage is a trading strategy that looks to make profits from small discrepancies in securities prices. The idea is that the arbitrageur arbitrates among the prices in the market to reach one final level. In theory, arbitrage is riskless.
It’s illogical for the same asset to trade at different prices, so eventually the two prices must converge. The person who buys at the lower price and sells at the higher one makes money with no risk. True arbitrage involves buying and selling the same security, and many day traders use arbitrage as their primary investment strategy.
Because so few opportunities for true arbitrage exist, most day traders looking at arbitrage strategies actually practice risk arbitrage. Like true arbitrage, risk arbitrage attempts to generate profits from price discrepancies, but like the name implies, risk arbitrage involves some risk.
You buy one security and sell another in risk arbitrage, but it’s not always the same security and not always at the same time. For example, a day trader may buy the stock of an acquisition target and sell the stock of an acquirer in the hopes of making a profit as the deal nears the closing date.
Risk arbitrage usually involves strategies that unfold over time — possibly hours, but usually days or weeks. Pursuing these strategies puts you into the world of swing trading, which carries a little more risk than day trading.
Contrarian trading: The logic behind a contrarian strategy is that nothing goes up forever; for that matter, nothing falls forever, either. The contrarian trader looks for assets than have been rising in price and sells them, and prefers to buy things that have been falling.
The point is not to buy cheap or sell dear, but rather to sell what seems to be overpriced and buy what seems to be a bargain. Contrarian traders fight the trend, which can work against them sometimes. This style favors people who know a market inside and out so that they know when to move against it.
Fibonacci series: The Fibonacci series is a list of numbers, each of which is the sum of the two numbers before it. It stretches into infinity but starts like this: 0, 1, 1, 2, 3, 5, 8, 13. Proportions based on the Fibonacci series show up throughout nature, and many believe that they indicate profitable trading opportunities.
Kelly criterion: Want to trade with a guarantee of success? Doing so is mathematically possible, using the Kelly criterion. In its simplest version, the percentage of your account that you trade is equal to the probability of the trade going up minus the probability of it going down. If your testing shows you that a strategy works 60 percent of the time and fails 40 percent of the time, then each time you trade with it, you would trade 20 percent of your funds ( 0.60 – 0.40 = 0.20).
Leverage: Day traders and other short-term traders aren’t looking to make big money on any single trade. Instead, their goal is to make small money on a whole bunch of trades. Because all those little trades don’t easily add up to something big, many day traders turn to leverage: They they either borrow money or stock from their brokerage firm, or they trade securities that have built-in leverage, such as futures and foreign exchange.
Momentum trading: Momentum traders buy securities when prices are rising and sell when prices are falling. The assumption is that something going up in price will continue to go up, and something going down will continue to go down. Momentum trading works well for many traders, especially in a strong bull market.
News trading: News trading is possibly the most traditional form of day trading. In this type of trading, the trader doesn't pay much attention to charts but waits for information that will drive prices. This information may come in the form of a company announcement about earnings or new products; a general economic announcement about interest rates or unemployment; or just a lot of rumors about what may or may not be happening in a given industry.
Pairs trading: A pairs trader looks for two related assets and goes long on the stronger one and short on the weaker. Many pairs traders work with stocks and look for two companies in the same industry, but a pairs strategy can be worked in futures and currency markets, too — going long on metals and short on interest rate futures, for example, or long on the dollar and short on the euro. The idea is to get the maximum return possible from a trend that affects both assets. These trades are a little more complex because you have to plan both sides.
Range trading: Range trading, sometimes called channel trading, starts with an understanding of the recent trading history of a given security, which involves looking at the charts to identify typical highs and lows during the day, as well as the typical difference between these two prices. With this information, the trader simply buys low and sells high.
When the security dips in price, the order to buy is placed; when it rises, the order to sell goes in. Range trading works in a normal market with just enough volatility to keep the price wiggling around during the day but not so much that it breaks out of the range and starts a new trend.
Short selling: Short selling is a way to make money if a security falls in price. In the options and futures markets, one simply agrees to sell a contract to someone else. In the stock and bond markets, the short seller borrows stock or bonds through the brokerage firm and then sells them in the hope that the price will fall, and then the trader can buy back the stock or bonds at the lower price to repay the loan. The trader keeps the difference between the security’s selling price and its repurchasing price.
Wash-sale rule: The wash-sale rule is a tax trap that catches many day traders. It says that if you sell a security at a loss, you can’t deduct the loss if you buy the same security 30 days before or after the sale. As a day trader, you may buy and sell the same security several times in one day. Ways to get around the wash sale rule do exist, but they require some planning and careful recordkeeping.
Zero-sum games and markets: A zero-sum game is one in which, for every winner, there is a loser. Many day trading strategies are zero-sum games. Options and futures markets, which are popular with day traders, are zero-sum markets. If the person who holds an option makes a profit, then the person who wrote (which is option-speak for sold) that option loses the same amount. There’s no net gain or net loss in the market as a whole.
Common Technical Indicators Day Traders Use
Day traders use technical analysis to look for price and volume patterns to determine whether a security is likely to do especially well or especially poorly. Here are brief definitions of some range, strength, and momentum indicators you’re likely to come across:
Average True Range: The True Range is found by calculating the exponential average of the difference between the higher of today’s high and yesterday’s close, and the lower of today’s low and yesterday’s close. Average these for 14 days, and you get the Average True Range. Usually, you sell a security trading at or above the high and buy one trading at or above the low.
Bollinger Bands: A Bollinger Band is a trading limit set at two standard deviations above and below the moving average of a security. Traders look to sell near the top of the band and buy near the bottom.
Commodity Channel Index (CCI): This index is used to identify seasonal turns in agricultural commodities and other securities that have different supply and demand levels during the course of the year. When a security goes above the CCI, it’s probably time to sell.
Momentum: Traders looking for momentum, buy securities that are going up in price if the volume traded is also going up, and they sell securities that are going down in price if the volume traded is going down.
Relative Strength Index (RSI): The Relative Strength Index is the average of the number of upward price movements in a period divided by the average of the number of downward price movements. The higher the RSI, the more interested people are in buying rather than selling.
Calculating Your Day Trading Performance
The goal of day trading is to make money, but when the trades are coming fast and furious, figuring out how you’re doing can be hard. Here are a couple simple ideas that let you gauge your performance as a day trader:
Batting average: What’s the number of winning trades relative to the total number of trades you make? This number gives you a rough idea of how often you’re making money, although it doesn’t tell you how much money you’re making. If at least half of your trades are winners, you’re on the right track.
Modified Dietz method: This is a quick way to gauge your performance when you have been adding money to your account or taking it out. What it loses in accuracy, it makes up for in simplicity. Here’s the equation for the Modified Dietz method:
EOY represents the end of year asset value and BOY represents the beginning of year value.