University for Forex Trading

Forex University

A Hard Look at Day trading

We receive more requests for articles and advice on day trading than on any other topic. Beginning traders are especially interested, particularly those that have been attracted by the glamour and intensity of the pit traders who seem to be constantly jumping in and out of the markets and reaping enormous profits.

It seems like almost all traders have tried day trading at one time or another. After all, it is very tempting to try and slug it out with the pit traders. Every tick is exciting. Every rumor or news item that affects the market either creates euphoria or is another nail in the coffin. When you have a position on, you can't stand the pressure, but if you're not in the market you tear your hair out every time prices act the way you predicted. Your heart pumps fast, your adrenaline surges, and you feel like you've finally arrived in the wild and woolly world of fast-paced futures trading.

All of this sounds like fun, but as you might imagine, there are many, many pitfalls along the way. We've come to realize, after talking to numerous traders who have attempted or are about to begin day trading, that most traders who start are not fully aware of the scope of the problems they face. To some readers the following discussion may be redundant, but we suspect that many of our subscribers may be embarking on a venture with only a limited grasp of the basics.

Cost of Doing Business is High
The day trader enters and exits trades during the same market session, normally a period of only four to six hours from opening to close. The very short term nature of day trading presents both advantages and disadvantages. The major advantages are the lower margin requirements and the absence of overnight risk. The disadvantages are the bad odds, time and effort required, the limited profit potential, and the burdensome costs of frequent transactions.

The transaction costs consist of both commissions and slippage. The commissions are a large and obvious cost of doing business. However the slippage is much more difficult to quantify. The trader might have a mental image of trading at the prices shown on a computer screen, but in reality he must continuously buy at the offered price and sell at the bid price. The spread between the bid and offer becomes a very substantial but hidden cost of doing business. In addition, as most of us have learned many times over, it is unrealistic to expect stop orders to be filled at our stop prices.

In the meantime, to offset these unavoidable costs, the day trader is limited to very small profits when he is correct in his analysis and completes a winning trade. Under even the most optimistic scenario, the day trader's potential profits are limited to a portion of the price range that is likely to occur within a few hours of trading.

Let us assume that our day trader has negotiated a discounted rate on his day trades and is paying twenty dollars per trade. Next let's be optimistic and assume that the spread between the bid and offer amounts to ten dollars buying and ten dollars selling. In order for the trader to complete a trade that nets $100 he must be smart enough to identify a move of $140 according to the prices on the screen he watches.

On the other hand, when his timing is wrong by only $140 he is going to lose $180. It doesn't take a Ph.D. in mathematics or an M.B.A. from Harvard to figure out that this is far from an ideal business environment. In fact, even the professionals on the floors of the exchanges must be intelligent, highly disciplined traders just to survive.

The public doesn't realize how many of these professionals fail in spite of the advantage of being on the floor and paying only minimal costs per trade. Imagine how small the odds for success must be for an off-the-floor trader faced with the costs we have described.

To have any hope of success, the day trader must strive to maximize the profits on the winning trades so that he can overcome the tremendous disadvantage of both the obvious and the hidden transaction costs. Unfortunately, the day trader has very little control of the potential profit to be obtained because the extent of the price range during the day absolutely limits the maximum profit that can be realized.

No trader can reasonably expect to buy at exact bottoms or sell at exact tops. A very good trader might hope to be able to capture the middle third of an infra-day price swing. That means that to make $180, the total price swing must be three times this amount or $540. How many futures markets have a daily price range of $540 or more? Very few. How many futures markets can produce a $180 net loss? Almost any of them.

Don't forget, the trader that is smart enough to find markets with $540 price swings and then smart enough to trade them correctly so that he nets $180 is only going to break even unless he has more winners than losers. To make money in the long run, the day trader must have a percentage of winning trades that is far better than 50% or he must somehow figure out how to make more than $180 on a $540 price swing. (or best of all, do both) This also assumes that the trader is smart and disciplined enough to harness his instincts and emotions and carefully limit the size of the losses.

Beating Tough Odds

As you can see, the day trader is faced with an almost impossible task. We would venture a very educated guess that less than one out of a thousand day traders make money over any sustained period of time. Our best advice is to not even attempt it unless you are one of the many traders who is actually trading for the recreation and mental stimulation rather than the money.

If you are serious about making money, your time and energy will be much better spent perfecting your longer term trading skills. Even if you should succeed at day trading, it is difficult to reinvest the profits and continue to compound them. Day traders can only operate efficiently in very small size so don't expect to make your fortune at it, it's only a very enjoyable but hard earned living at best.

In spite of our sincere warning, we know many of our readers will attempt to beat the odds and become day traders for a while. Fortunately, the lessons learned while day trading can be applied to more serious and productive trading later on. In the meantime, we will do our best to explain as much as we can about day trading and hopefully make the learning process less costly.

Obviously, we don't have all the answers ourselves or we wouldn't have such a negative outlook on the probability of success. We certainly have learned a great deal about this subject over many years of trading and the fact that we have elected to no longer play this game simply demonstrates our personal preferences in the allocation of our productive time. We hope whatever hard-earned information we can pass along proves helpful.

Selecting Best Markets For Day Trading

As we pointed out earlier, there are very few markets that have wide enough infra-day price swings to make them suitable candidates for day trading. Because they must monitor the prices so closely, day traders generally prefer to concentrate their efforts on only one or two markets. In addition to the fact that the prices must be watched continuously, there are very few markets that are suitable even if we had the capacity to follow more of them. Presently, day traders seem to have given up on pork bellies and tend to favor the stock indexes, bonds, currencies, and energy markets. From time to time other markets may become candidates for day trading because of temporary periods of high volatility.

We ran a test (several years ago) to see what percentage of the time various markets had a total daily range of $500 or more between the high of the day and the low. There were only five markets that had a $500 range at least two days a week or 40% of the time.

In addition to looking for a wide daily range, liquidity and the size of the minimum spread should also be factors to consider when selecting suitable markets for day trading. Our previous example of costs included paying a spread of only $10 on each side of a trade.

In the S&P market a minimum spread would be $25 each side while in the bond market a 1/32 spread is $31.25. If you are day trading bonds with $20 commissions, you must overcome total costs of $82.50 added to losses and subtracted from gains. Your average winning trade must run $165 farther than your average loss just to break even. This assumes a 1-tick spread which is the best case possible.

The element of liquidity comes in to play in determining the number of ticks in the spread between bid and offer. A one tick spread is the best you can hope for and most markets have a wider spread than that.

You can usually assume that the higher the average daily volume, the tighter the spread. For that reason, you will want to concentrate your day trading in only those markets with very high volume. Otherwise, you can be making good timing decisions and still be assured of losing money.

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