Many American investors are captivated by the possibility of signing into a brokerage account at Fidelity, Schwab, E*Trade, Ameritrade, or elsewhere, and making a quick in-and-out profit by day trading in the stock market (or options or forex market). Day trading has held its appeal through all of the recent --and not so recent -- market moves and volatility, because of wild stories of huge profits based on amazing market timing. Of course, the volatility and chop of the market has likely made many more losers than winners, but we hear very little from them. Some would argue that this increased volatility is why trading, and not investing, is the only viable choice for individuals in the market. However, day trading has real immense risks, and what I call a clear and present danger. If you decide to day trade anyway, understanding and considering these risks can help you succeed.
Here is a list of THREE BIG RISKS to consider when day trading:
To have the ability to enter and exit a position intraday, without full financial settlement, most brokers require a margin account. Margin is essentially leverage that gives a trader access to some of the broker's money (with interest) using his own individual funds (cash), or stocks/bonds/mutual funds in the same account, as collateral. The dangerous aspect about margin is the common multipliers of 2x or 4x underlying capital. Traders assume that this simple access to additional capital beyond their own will make it easier for them to reap the rewards of day trading.
The main problem with day trading on margin is the trading losses. All the losses belong to the trader and will change the ongoing calculations with the leveraged, or borrowed capital. If this continues, the day trader can potentially lose more money than he started with. To avoid this possibility, the broker has the right to request that more funds are deposited, or to simply liquidate a trader's positions at any time if the market moves too much against the holdings, and their margin capital is in danger. Many day traders have been wiped out by margin and Fed calls that force liquidation of their holdings at the worst possible times.
Market Psychology Risk
The stock market can most simply be thought of as a marketplace of buyers and sellers. It is where companies go to raise funds by selling ownership shares in the form of stock to private and institutional buyers. Whether those shares are bought, sold, or held at any given time is based on the 'crowd' mentality of the market participants. Often when everyone wants to buy, or own, a stock, it is probably getting to be too expensive, and you should consider getting out; when everyone sells a stock, value investors often purchase the downtrodden shares and wait for their possible acceptance by the market again.
The problem is that individuals are prone to exaggerated emotional responses to changing market conditions. They often buy too soon, and sell too late. They keep watching their losing stocks sink lower and lower, and often clip their winners to take a quick gain -- they never learn the lessons of proper risk management.
As a day trader, understanding proper entries and exits is even more important. You need to develop market discipline with specific rules that minimize risk, and help you construct a trading plan. A trader in control of his/her emotions will find a proper strategy to make money. Traders who get too emotional, almost to the point of manic reactions, will often lose all of their trading capital quickly, especially while trading on margin.
Day traders need the skills to calmly exit a position, change from going long to short (expecting the price to drop), and to learn to scale in and out of winning trades. These skills are developed slowly over time, in many market conditions, and help the trader develop techniques, strategies, and disciplines - not at all like gambling - but built on methodologies of controlling risk. Traders must not try to be right about a position, but rather they should attempt to simply make a gain, or exit the trade and move on.
The risk with liquidity for the individual day trader is two-fold. On one hand you have limited funds (even if you won the lottery), but the institutions on the other side of your trades may have billions of dollars at their disposal. The market-movers can drive a stock's price up and down throughout the trading day, and bounce you out of your positions if you are not careful (with stops and exit prices). The famous saying that the stock market's irrationality can always outlast your liquidity applies here.
This is why many traders close every position at the end of the trading day. The risk of holding positions overnight, through a weekend, or market holiday, is often too great for someone trading largely on technicals (charts of a stock's support and resistance), rather than fundamentals (underlying company's financial health.)
The second risk which often counters a new day trader's success is the need to remove money from their trading portfolios. If you need liquidity from those funds to support your lifestyle, then that money should NOT be in the market. Even if you only remove gains, you will never lessen your need for margin, build capital, or create a larger financial buffer from draw-downs. Many day traders fail because they attempt to live out of their portfolio accounts. You can imagine the psychology of trading being affected by the fact that a trader must withdraw funds to pay rent, mortgage, or some other bills by the end of the month. It's a distracting scenario for a day trader, and it makes trading even more emotional and precarious.
One way to approach these clear and present dangers is to not consider day trading a viable job until you have the necessary tools, and have developed the skills, to consistently make money. For many this means paper trading while you accumulate funds. When it's time, you need to have sufficient trading capital --essentially money you could afford to lose -- alongside funds for living expenses that are not in the market, and perhaps even separate emergency reserves. For most of us, this can be accomplished only very slowly over a long period of time. For many people, it is better to invest with a longer time horizon, and it is simply too dangerous to day trade. In the preface to his book "New Market Wizards: Conversations with America's Top Traders", author Jack Schwager reminds us that "there are a million ways to make money in the markets. The irony is that they are all very difficult to find."
Good luck investing, or if you choose, day trading. Be sure to consult your own advisors and/or financial professionals before you commit any risk capital.