Pros and Cons of Day Trading Versus Long-Term Investing
Day trading and investing for the long term are both viable forms of securities trading, and many traders opt to do both. Day trading involves making trades that last for seconds or minutes, taking advantage of short-term fluctuations in an asset's price. With day trading, all positions are opened and closed within the same day.
Long-term investing, on the other hand, consists of making trades that stay open for months, and often years. These are buy-and-hold trades, rather than quick, buy-and-sell-trades. The decision-making process for a day trade can be quite different from a long-term investment with different skills and, in some cases, personality traits required for each. There is also a middle ground between investing and day trading called swing trading, which is when trades last for a few days to a few months.
Day trading and long-term investing differ in terms of capital requirements, time commitments, skills and personality requirements, and potential returns. Both day trading and holding some long-term investments are important parts of a diversified investment strategy, although buying and holding investments offer a more passive form of income and wealth generation than the constant vigilance and work of day trading.
If you are just starting out in the markets though, and you're trying to decide where to focus your efforts first, consider the following four areas that can help you make a decision.
Minimum Capital Requirements
To day-trade stocks in the U.S., you'll need to maintain a brokerage account balance of at least $25,000. There is no legal minimum capital requirement to day trade in the currency markets, but starting with $1,000 is recommended. If you want to day-trade futures, it's best to start with at least $5,000 to $7,500.
Long-term investing is typically done in the stock market. Futures have an expiry date, so they aren't ideal for long-term trades. Currencies can be used to trade long-term, but options are limited since it doesn't make as much sense to open long-term trades in an environment of relatively few stable and investable currencies, as compared to the thousands of stocks and ETFs to choose from, which can also be used to trade futures and currencies indirectly.
Depending on how you opt to invest, the required starting capital varies. There is no set minimum you need to invest, but it's important to consider commissions carefully when you make trades using only small amounts of capital.
An Example: The Cost of Trading Commissions
Assume that your broker charges a commission of $7 per trade. If you're buying $100 of stock at a time, the commission equates to a pretty hefty 7-percent fee, deducted from any profit you make. Compare this to a person who buys $1,000 of stock at a time; the $7 fee is only 0.7 percent of her capital. While the commission charge stays the same, when compared to capital invested, the fee is much more expensive percentage-wise for an investment of a small amount of capital.
Keep in mind, you'll also pay another commission when you sell your position. On a $100 investment, you'll need to make 14 percent just to break even, which is a much bigger handicap than the person who invests $1,000 at a time and only needs to make 1.4 percent to break even. Deploying capital in larger chunks is much more profitable.
Try to save up at least $1,000 of investment capital before making a stock or ETF purchase (many ETFs can be invested in commission-free, with certain brokers). This way, commissions don't take such a huge percentage chunk of your capital for each purchase.
Differing Time Commitments
Day trading requires a daily commitment, typically of at least two hours. The first hour that U.S. markets are officially open for trading is typically one of the best times to capitalize on large price moves. As lunchtime approaches in New York, stock activity tends to quiet down.
Your best "bang for the buck" comes from trading during the market's opening hour or two, with a bit of prep time before the open. Day traders should also spend time reviewing their trades each day and at the end of each week.
Total time commitment: about 15 hours per week on the low end, and up to 40 hours per week on the high end (if trading most of the day).
In the U.S. market, the most active time for stocks, currencies, and futures is near the market's opening time each morning. Alternatively, global markets also tend to be active (especially currencies and European stocks) near the European open. If in the U.S. or Canada, these are ideal times to trade, which means trading in the morning or the middle of the night. If these options don't work for you, day trading may not be a good fit, and you are better off investing for the long term.
Investing for the long term, and the research that goes into it can be done at any time, even if you work many hours at an office job. When capital is ready to be deployed, expect to spend a couple hours per month looking through stocks and finding which ones meet the criteria of your investment strategy (finding or creating an investment strategy will take up more time in the beginning).
Some people choose to be more active and may spend a couple of hours per week doing research (especially if they have lots of capital to deploy and are looking for multiple trading opportunities). For the "set and forget" investor, they may only need to do a bit of research, or check on their investments, every few months, possibly when they are ready to make another purchase.
Skills and Optimal Personality Traits
Any type of securities trading requires a serious time commitment up front to research and create a strategy that works. You'll then also need to spend time learning how to implement your strategy effectively, as new traders will often deviate from their plan or strategy because of the strong emotions that inevitably arise when their capital is on the line.
Day trading and investing both take emotional discipline. Trades must be opened and exited according to specific trade triggers provided by your preformulated, and preferably back-tested strategy. Emotionally entering or exiting trades when a trade trigger is not present is undisciplined and likely to lead to poor performance.
Day trading and long-term investing both take patience, but a different sort of patience. Day traders are active, potentially taking many trades a day, although they still need to wait for their buy and sell trade triggers to occur. Watching each little price movement can easily seduce a trader into making a trade when they shouldn't.
On the other hand, long-term investors must also act only when a trade trigger occurs. They are not constantly watching their positions and worrying about every penny of fluctuation (or, at least they shouldn't be), so the temptation to trade happens often. Either way, an investor must still learn to only take trades when a valid trade trigger occurs, even if that means looking through charts for weeks without finding any good opportunities.
Successful day trading and investing requires smarts, but not necessarily book- or college-smarts. All traders must convert book-smarts into usable knowledge. That means distilling everything down into a few simple concepts that you find easy to follow. So read books, and take from them what you like.
Do this until you have a method for entering, exiting and managing risk on your trades. Test out the method on historical data, known as back-testing, to see if it works. Get comfortable making trades with this strategy in a demo account. Then, when ready, implement the strategy with real capital. Occasionally, you may need to make some tweaks to your system or strategy as you gain experience and find better ways of doing things.
Which Offers Higher Potential Returns?
You can attempt to compare potential long-term investment returns and day-trading returns, but it's like comparing apples to oranges. Day trading requires a significant time investment, while long-term investing takes much less time.
You can amass millions of dollars in long-term investments with little impact on performance, whereas day traders will likely start to see a decline in percentage performance even with an account of several hundred thousand dollars (it becomes harder to deploy more and more capital on trades that only last minutes). Because of these discrepancies, there is a big difference in the potential returns of day traders versus investors.
Day traders can make 0.5 percent to 3 percent (on the high end) per day on their capital. That may not sound like much, but it could equate to 10 percent to 60 percent per month. Higher return percentages may be possible on smaller accounts, but as the account size grows, returns are more likely to shift into the 10 percent per month region or less.
With day trading, gains compound quickly. For example, if you start with $30,000 and make 10 percent per month, the next month you're starting out with $33,000. If you make 10 percent again, now you have $36,300 to invest. Compounding occurs daily since profits are locked in daily. That means you make gains on prior gains (in addition to any additional deposited capital), so your account might balloon rather quickly. Unfortunately, a day-trading account can also decline rapidly if you're losing even 1 percent or 2 percent of your capital per day.
Most individual investors don't need to worry about accumulating too much capital. With loads of stocks out there to choose from and a longer-term time frame to accumulate and dispose of positions, the long-term investor has averaged about 10 percent per year.
That average takes place over a long time frame though, as any given year could see returns much higher or lower than 10 percent (with negative returns occurring about one out of every four years). Active and skilled investors can outperform the 10-percent average, as certain strategies have shown a tendency to produce 20 percent or more per year. Since investments are often held for years, compounding takes place more slowly.
If trades last several years until the profits are realized those gains can't be used to produce more gains. The rapid compounding is one advantage of shorter-term trading. As mentioned though, it is harder to deploy more and more capital on short-term trades, so doing some long-term investing in addition to short-term trading helps to round out your portfolio returns.