For most people, the stock market is an opaque and confusing thing. We know that it’s a way to grow wealth, and we know that we should be investing in our 401k and using the stock market to help us reach our retirement goals. We try to save the right amount and invest it, we put it in an index fund or a target-date fund, and we wait — most of us, anyway. But not day traders.
Day traders are active investors. They do so much more than just save money, buy stocks, and hold them. Day traders use all kinds of advanced moves and complex strategies to make money faster and “beat the market.”
Sometimes it works. Sometimes it doesn’t. Being a day trader requires financial smarts, a talent for trading, and a fearlessness and calm in the face of risk and chaos. Day traders apply complex strategies to a market that often defies prediction. Here’s how they should go about it.
Understanding the market
The key to any intelligent day trading strategy is understanding the financial logic that underlies it.
Take a shooting star candle stick strategy, for instance. In this strategy, investors use a “candlestick chart,” which shows the high, low, open, and close prices of a given investment over a given period. A certain formation that can appear on this graph is called a shooting star. That formation indicates that the price of the security may start falling. This means that an investor following the shooting star strategy should be bearish on this investment, which means selling it or perhaps even shorting it.
But to get to this point, an investor needs to know what shooting stars and candle sticks are, as well as what they actually mean and why this strategy works the way that it does. A conceptual understanding of the market will keep an investor from relying on formulaic assumptions.
Understanding your tool kit
Understanding the market will help you make educated guesses about what direction certain investments are headed. But to act on that knowledge, you’ll have to understand your tool kit.
Your brokerage account will allow you to buy and sell stocks, of course. But as an active investor, you may want to use more complex techniques. You may want to buy or sell options, for instance, or even trade on margin. As a day trader, you should take the time to learn about all of the mechanisms you can use in order to take a position on a security, from the simple market order to spread options schemes.
We can learn a lot about the market without considering our own practical risks. We can talk all day about shooting stars and bears and bulls. We can predict that stocks will go up and down, and we can talk about how to take advantage of that. But day traders need to be particularly conscious of their risk, because not all ways to make money on the market are created with equal risk.
When you buy a stock and hold it, your risks are limited. The worst thing that could happen would be the company going belly-up. Your potential losses, however unlikely, are equal to what you paid to acquire the stock. But some other moves day traders can make have much greater potential losses. If you short-sell a stock, for instance — promise to sell it to someone later on despite not owning it — you could reap big gains if the stock drops in price (because you could buy it, then sell it for the larger agreed-upon price), but your losses are technically unlimited (because the stock could rise in value, and there’s no saying how much it could go up by).
As a day trader using complicated strategies, you’ll need to become very adept at evaluating your overall risk. This can be a complex thing, because you’ll be exposed to risk in multiple ways. Take trading on margin, for instance. Some brokerage accounts will let you trade on margin, which is great, because you can borrow money to invest in order to make money faster. You’ll be at risk in that you might miss your bet and lose money — but will still have to pay your brokerage back everything you borrowed. That’s obvious, but remember the other complications. For instance, how much your brokerage allows you to borrow will be based on the value of your account. So if you lose big on a risky trade and make your account worth far less than it was the day before, your broker may suddenly be calling you and demanding that you add funds to your account — or else they might sell your stocks without your permission in order to cut losses and regain what they lent you.