Day-trading overview

Day-trading, which was once the exclusive domain of the floor trader, is now fair game for all speculators. Inspired in part by large intraday price swings, instant availability of quotes, affordable high-powered computers and competitive commissions, the new wave of day-trading methods and systems has attracted thousands of traders in recent years. The undeniable thrill of trading within the time span of one day is, however, a double-edged sword: one that can hurt as well as heal. To be successful, a day-trader must have the discipline of a machine, the instincts of a fox, the emotions of a rock, the skills of a surgeon and the patience of a saint. (And a little luck wouldn't hurt either.)

What is it about day-trading that attracts so many speculators to the markets? Are there effective methods for day-trading? Is successful day-trading more luck than skill? Is day-trading the proverbial "crap shoot?" Can day-trading be learned? Is the successful day-trader a different breed of "cat" than the successful position trader? Does day-trading offer advantages above and beyond position trading? Read on for the answers.

Day-trading defined In the summer of 1968, after making my first few trades in the commodity market (as it was called then), I learned quickly that floor traders clearly had the "edge" over the public. Floor traders were in the pits where the action was. They knew prices before the rest of us did. They traded for minimum commissions, and they seemed to know the news that affected prices before the rest of us. During one of my visits to the Chicago Mercantile Exchange, I was chatting with a retired floor trader in the visitors' balcony, and he asked what my trading interests were. I told him I was there to learn, that a broker was handling my account and that my knowledge of trading was very limited. He asked me if I was a "position trader" or a "day-trader." I confessed I hadn't heard either of those terms before. He offered the following definitions: A day-trader trades within the time frame of one day, entering and exiting positions within the day but always closing out trades by the end of the day, win, lose or draw.

This definition seemed logical enough to me. But the "old timers'" definition of position trading gave me cause to stop and ponder momentarily. He defined the position trade as a day-trade that ends the day at a loss.

After a few moments the definition struck home, and I laughed. But under the surface of my apparent amusement was an inherent market truth that has not left my mind since that day. Clearly, the ability to take a loss by the end of the day likely may be the salvation of many traders because the vast majority cannot take their losses when required to do so by their system(s), assuming, of course, they even have a system!

Giving up old ideas While many traders strongly oppose day-trading, I disagree. The long-standing "bad press" that has been given to day-trading and day-traders needs to be re-evaluated and abandoned. As I noted previously, computer technology and competitive commissions have changed day-trading forever. In fact, when examined logically in terms of the assets and liabilities of day-trading in comparison to position trading, the balance tilts clearly in favor of day-trading. Here is my list:

And there may be many other pros and cons as well. Of the above, the most significant pros are (1) forced to exit losses and (2) immediate feedback of results. Think at length about these two cogent benefits of day-trading, and I suspect you will agree with my assessment. But enough of philosophy and psychology -- let's get on with techniques and methods.

Technical day-trader Note that I consider the day-trader to be the ultimate technical trader as opposed to a fundamentalist. While fundamentals may rule a market in the long run, they are not nearly as important within the time frame of a day, other than, perhaps, to result in price swings based on news. The effective day-trader has methods for capturing moves based on the emotional response to fundamentally based news.

In my book, The Compleat Day Trader (McGraw-Hill, 1995), I distinguish between four basic approaches to day-trading: trend following and support/resistance trading. All are viable methods, which, alone, mimic what I consider to be the four basic technical methods of position trading. Here is a brief overview of each method as well as its assets and liabilities:

* Trend breakouts and trend following -- Of all the trading methods, following new trends or buying on breakouts to the upside and selling on breakouts to the downside ultimately may prove to be the most effective. In so doing, a trader follows prices higher or lower, taking stock in the belief that "new highs beget new highs" and "new lows beget new lows." Breakout systems date back to the excellent work of Keltner in the 1960s who pioneered various methods for taking advantage of price highs and lows for a given time frame. "S&P 500" (right) shows the ideal situation for a day-trader who buys a "breakout" of resistance. The good news here is although buying breakouts to the upside or selling breakouts to the downside tends to work well, it is psychologically difficult for most traders to do, and it requires traders to reverse positions when wrong. There are numerous methods for finding, validating and managing the risk in breakout systems.

* Support and resistance trading -- This approach appears to make the most sense to traders. It involves two aspects: First, a trader must determine the underlying trend of the day and second, once the trend has been determined, a trader must determine the technical support level in an uptrend and the technical resistance level in a downtrend. When the trend is defined as up, a trader will buy at support levels, and when the trend is defined as down, a trader will sell at resistance levels. Profit taking and risk management strategies accompany this approach. While you may think this approach is obvious and self-evident, few traders actually can define the above terms operationally.

* Daily seasonal trading -- Very few traders use this approach, yet I think it is a viable and worthwhile method. The pioneering work of Art Merrill in his classic book, The Behavior of Prices on Wall Street, clearly demonstrates the statistical reliability of pre-holiday behavior in the Dow Jones Industrial Average. Merrill showed that the odds of a higher-price close on the day before major U.S. holidays were not only very high but also statistically significant. Yale Hirsch in his outstanding book, Don't Sell Stock on Monday, demonstrated the value of using day-of-week statistics for market timing and trading. I have extrapolated from both of these works to determine the percentage of time the various futures markets have closed the day higher or lower than the previous daily close. Naturally the reliability of such data is a function of the data history. "Daily seasonal composite" (above) shows a portion of the daily seasonal futures charts I have developed for this purpose.

* Daily sentiment trading -- The pioneering work of R.E. Hadaday in developing his Bullish Consensus indicator was instrumental in my development of the Daily Sentiment Index. The index provides a measure of public sentiment on a daily basis. This allows day-traders who follow a contrary opinion approach to fade the public sentiment when it reaches to levels that are too high or too low. The theory is that when daily sentiment is at 90% bullish or more, the public will be wrong, and hence, the day-trader will look for timing signals to trigger short-side entry and vice versa when the sentiment is 10% or lower.

Risk endures These are the major technical, philosophical and psychological issues the day-trader faces. They don't differ significantly from the issues that face the position trader. The only major difference is the time frame.

Because our world is growing rapidly smaller, and because market moves tend to be larger now within the smaller time frames than ever before, day-trading is not only viable and manageable but also preferable in many cases for the reasons cited previously. Of course, the viability of day-trading methods does not negate the risk of trading. Risk always lurks under the surface. No trading method is complete without an accompanying method for managing risk and dealing with the reality of losses, commissions and the cost of stock quote, equipment and time.

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