Let's get started and review what day trading is and how it differs from other forms of trading activity. Day traders by definition do not hold positions in securities overnight. Typically, the day trader makes and holds trades for only minutes at a time, most commonly for less than an hour. Operating in this fashion requires a very disciplined approach that includes accepting loss as part of the cost of doing business. It is not possible to make every trade a winner. In fact, I know of people who make lots of money being right only half the time in the trades they make.
The key to making money while day trading is limiting your losses and taking profits when you can. Not only does this take a methodical approach, but the approach must be based on the reality of what is happening to the asset you hold, not the hope of what may happen to it in the future.
For those who have held investment accounts, concepts such as doubling down, which may work well for longer-term trades, are potentially disastrous in day trading. Doubling down is the practice of buying a security, and if its price falls, you buy more in order to lower your average cost. That way, you can make money even if the security does not get back to your original purchase price. When day trading, these types of tactics fall more into the hope than the reality column, and they definitely do not contribute to a disciplined approach. As I will say again and again, discipline is the key to survival and profitability in the day-trading game. Making an investment decision to trade in securities that are then held for years at a time generally comes as the result of fundamental analysis of a company's business. You then apply some sort of valuation model to the share price and become convinced that the share price should be higher. The day trader cares nothing for this sort of analysis. Day traders only care about finding imbalances between supply and demand, and taking positions in securities that take advantage of those temporary imbalances.
Day trading is inherently different from swing trading too (swing traders hold a security over the course of one or two days). The day trader must keep tighter stop losses and have the discipline needed to keep them. In addition, swing traders rely heavily on several types of technical analysis, often far more sophisticated forms than a day trader will use. Day traders need to react quickly to take advantage of the low-risk, short-term moves that result from supply-and-demand imbalances. Using complex analytical methods will never be useful to pure day traders. To properly absorb the information delivered by that type of analysis will take so long that the best entry point will be long gone. Taking inappropriate trading methods that may work well in other circumstances and applying them to day trading is a sure path to high risk and, ultimately, losses.
Here is a useful analogy for describing how day trading differs in concept and execution from longer-term forms of trading. Think about someone taking a dog for a walk through some wooded land using an elastic leash. The paths that the person and the dog might take are illustrated in the below figure.
Think of the path the dog takes as representing the intraday movements of a security and the path the owner takes as representing the closing prices of a security on a daily chart. We know that the elastic leash will tend to bring the dog back toward the owner, and that the things that make the dog dart from one side of the owner to the other are more predictable than the course the owner will take. The dog is a simple, predictable creature who will chase a rabbit or head off to sniff a tree. It is more difficult to predict the owner's path, because it depends on his or her skill at map reading and knowledge of the terrain. This analogy captures the basics of my day-trading approach. The technical indicators presented are quite good at predicting shortterm intraday movements. They are less good, however, at telling you where the security is going to close for that day, or any other day.
However, back to a fuller description of this analogy. The dog owner wants to get from point A to point B. Due to the difficult terrain, she cannot go in a straight line. By plotting the paths that the dog owner and the dog take, we generate the graph shown in the above figure and can illustrate the differences between the three approaches to buying and selling securities (longterm, swing trading, and day trading).
The long-term investor looks for a return from an investment greater than what would be gained by placing the funds in an interest-bearing account. The investor will pick a company with a management team in which he or she has faith to navigate the business landscape and return a profit at some point in the future. The company the investor picks may be viewed either favorably or unfavorably by the market at different points during the lifetime of the investment, but that is of little concern. As long as the fundamentals and management team remain intact, the investment is held in the belief that profit will come. This is the Warren Buffett type of trading decision. To make an analogy for this type of trading, we would pick a dog owner we believed would be able to navigate from point A to point B and not worry that detours are necessary to get there. In other words, the path the dog owner takes does not concern us. We firmly believe that the owner will get there in the end. The fact that the dog is pulling the owner off course occasionally only registers as insignificant noise in the overall scheme of things.
A swing trader pays more attention to patterns in the path of a security and seeks to capitalize on moves that occur over several days. For example, if we think of the above figure as a chart showing daily stock price movements, a swing trader might enter a position at point P1, believing the security has pulled back to levels of support, and exit at point P2, believing a topping formation is in effect. P3 might be viewed as another potential entry point. This form of trading focuses on the path the dog owner is taking. We're less concerned about whether the owner gets from point A to point B. Any effect the dog has of temporarily pulling the owner away from his chosen path is, again, seen as temporary, and not something that will take the owner off course. Here, the dog owner's path is analogous to the closing price of the security, and the dog's tracks are analogous to the intraday swings.
To apply the dog and dog owner analogy to day trading, we focus almost entirely on the tracks the dog takes. The idea that a stock price might behave like a dog, which, as a result of seeing a rabbit or some such event, might bolt in the opposite direction from its owner is key to daytrading activity. If the dog does indeed bolt in the opposite direction from its owner, the elastic leash will ultimately pull the dog back on track, and it will have to forget the rabbit or whatever it went in search of. We don't know when the dog will reach the limit of the elastic, or of his desire to chase the rabbit, and head back to the owner, but we do know that eventually he will. This concept is most easily applied when trading the market open, when we look for large premarket moves in a security that we expect to correct at least partly once the initial run has been made. We will see later that when trading at the market open, a security that makes a big move in the premarket (almost always due to a news story of some kind) is even more attractive when that move is in the opposite direction to the overall trend for that security. In this scenario, it is even more likely that the short-term move will expire and the price will come back closer to the premove price. In this little parallel world, news items are like rabbits, frequently enticing the dog offtrack with great strength, countered, of course, by such external factors as the leash and the owner's desire not to be diverted.
We can also use our analogy for trading stocks after the market-open period. During this time, we seek to identify a trend and trade in the direction of that trend on a very short-term pullback. That is analogous to seeing the dog go off to sniff a tree, first on one side of the owner's tracks, then on the other. We know the dog will lose interest in the tree fairly quickly and will then head off in another direction, most commonly on the opposite side of the owner. Applying that thinking to day trading, we seek to identify what the current trend to the security is, i.e., the direction the dog owner is headed, then trade at a point where we think the security has traded against that trend and reached support. Again, this is analogous to the dog straying away from its owner until it reaches the limit of its elastic leash and getting pulled back toward the owner.
As a day trader, you don't care where the security's price ends up. You are just interested in riding parts of the short-term intraday swings.
