Many misconceptions surround the life of a day trader. Those looking to sell you a stock picking service will make it seem like a elegant life filled with easy wins and clear computer screens by lunchtime. As long as you have the secret sauce, you can make riches in the market every day.
Unfortunately, this lifestyle only exists on Instagram and Twitter. Day trading isn’t like riding a bike or training for a new job, it’s a grind that requires constant attention and lots of prior research. Successful day traders aren’t looking for big home-run trades. Instead, they try to compile lots of little winners which build up into big profits over time.
If you’re working toward profitability as a day trader, the first important lesson you should learn is about minimizing mistakes. One of the reasons so many day traders fail is because they let their emotions get the best of them and veer off their planned path. You need to have a short memory because mistakes will happen and you’ll need to move past them quickly. That being said, here are a few common errors that can be avoided with a little forethought.
Not Having a Trading Plan
What kind of day trader do you want to be? Are you someone who wants to stick to trading only stocks or options? Do you want to jump more into forex and futures? Are you more of a scalper or a momentum trader? And one more – if you can’t answer any of these confidently, how can you expect to have success in an unforgiving market?
All traders need to have a plan, but day trading without one can be especially hazardous. Most day traders don’t mess around with different asset classes or trading strategies, they stick with what they know best and make minor tweaks instead of wholesale changes. It’s always best to go in with a plan as a day trader. After weighing your options, you might even decide that swing trading is more your style.
Risking Too Much
Day trading can be difficult because you need to forget your losers quickly and move on to the next trade. Like an NFL cornerback who gets beat deep, you need to have a short memory and get back in the game with the same level of confidence. Losses happen, you can’t get discouraged by a string of bad luck.
Unfortunately, bad luck is a difficult concept for emotional investors to understand. Gamblers who hit cold streaks are prone to tilting, meaning they increase the size and frequency of their bets in an attempt to win back their losses. Of course, this only causes losses to compile.
For new day traders, taking on too much risk is the biggest threat to your survival and it often happens after a string of bad luck. If you encounter a couple losing trades in a row, it’s important to stick to your plan and not risk more than you set in your initial parameters.
One of the best rules a new day trader can follow is the 1% Rule, which states that no single trade should involve more than 1% of the capital available in your account. If you have a smaller account, you can tweak this rule to 2% or 3% in order to get worthwhile position sizes. But also keep your trades small to start – you don’t want to blow up your account making beginner mistakes.
Cutting Losses Too Late
Another fallacy new day traders fall into is the belief that losses can be recovered if they hold on to stock or contract. At this point, the trader is just looking to ‘break even’ on the position and get back to their original starting price. Unfortunately, this is a losing mentality.
If you’re a buy-and-hold investor, you have plenty of time to let your investments recover from rough times. Even great companies like Apple and Amazon suffer 10% or even 20% declines at times. But day traders don’t have time to wait for these recoveries since no positions are held overnight. Don’t let ideas about ‘getting back to even’ enter your mind when day trading. This isn’t intramural soccer where everyone gets to play – you need to cut losers quickly and without mercy.
Not Using Stop-Loss Orders
One risk management tool that day traders can use to minimize losses is a stop-loss order. A stop-loss order is placed when a trader wants to automatically exit a position when the price drops to a certain level. If you purchase shares of XYZ corp at $20 and are willing to risk 20% of your capital, you can set a stop-loss order that will automatically dump the stock if the price reaches 18%.
Additionally, you can set a trailing stop order, which functions like a stop loss but follows the price if it moves upward, like a detective trailing a suspect. The trailing stop loss can be set to follow a certain percentage or dollar amount behind the price of the shares.
Using Too Much Margin
Borrowing money to increase stock returns is a popular strategy amongst traders. When you borrow money from your broker to buy stocks, it’s called buying on margin. Let’s say you borrow $2000 against the $2000 in your account and buy $4000 worth of stocks. If your investment grows by 20%, you’ll have $800 in profits. Since you borrowed money, you earned $800 on only a $2000 initial investment. After returning the borrowed $2000 to your broker (plus any associated fees), you’ll have $2800.
Of course, margin can also work against you. If your investment LOST 20%, you’d be down to $3200 on the $4000 investment. But your broker will still be expecting the full $2000 in borrowed money back, so your 20% loss will actually leave you with $1200 – a real loss of 40%. Misusing margin can be brutal for inexperienced traders since it could result in a margin call. If your broker issues a margin call, you’ll need to return the borrowed cash ASAP. In fact, your broker can actually liquidate your holdings without your consent to recover the debt. Use margin carefully and always within proper risk parameters.
Chasing After Trends
Trend following is a popular trading strategy, but day traders could struggle with it since trends often take a long time to form or change. If you think you can day trade based on breaking news, earnings reports, or economic data, you’ll likely be disappointed in the results.
Chasing after trends that have already been priced in is no way to day trade. If you want to have success, you’ll need to follow a different type of trend like momentum, support or resistance, or other technical indicators that provide clues to incoming price shifts. But don’t blindly follow the crowd because the crowd is often wrong. In fact, day traders often find more success being contrarians.
Final Thoughts
If you’re looking for a golden ticket to surefire day trading riches, be prepared for a long infinite road since such a ticket doesn’t exist. Day traders don’t have a secret sauce or a 100% winning formula. If you want to see magic, you’ll have to load up Harry Potter on Disney.
What day traders actually do is follow a strict set of rules and minimize mistakes as best they can. No trader wins all the time, but the good ones know when to bail out of a losing trade and look for the next potential winner. If you’re new to the day trading game, you’ll need to develop a plan and practice until it becomes second nature. Whether it’s using simple support and resistance levels to locate profitable equities or scalping currencies with moving averages, find your niche, hone your technique, and stick to your rules if (or when) things go awry.