On the surface, day trading looks like it should be easy. Jump in and out of trades as the price moves, make a little profit and repeat the process tomorrow. Unfortunately, many dangers are lurking in the markets for day traders and new day traders are unaware of these dangers and how they can drain their trading account.
In this article, we provide an overview of how day traders can avoid the common pitfalls of most traders.
- Day trading can be profitable, but new day traders typically lose money.
- The biggest danger new day traders face is not having risk management protocols in place, or having an incomplete risk management strategy.
- Successful day traders test out a strategy in all different types of market conditions and learn the strengths and weakness of a strategy before using it with real capital.
- Work on developing solid trader traits, and implement strategies for reigning in any problematic tendencies you notice in yourself.
Lack of Risk Management
The biggest danger new day traders face is not having risk management protocols in place, or having an incomplete risk management strategy. New traders are usually optimistic about their trading skill (why start trading if you aren't optimistic about its potential), which can lead them to overlook important risk management steps.
Here are some steps to take to establish a basic risk management strategy.
Control your risk on each trade by placing a stop-loss order on every trade you make. When starting out as a day trader, your risk on a single trade should never exceed 1 percent of your trading account balance. The risk is defined as the difference between your entry price and stop loss price, multiplied by your position size or how many shares or lots you purchased.
A Daily Limit
Controlling your risk on each trade is a good start, but if you initiate a lot of trades each day and lose on the majority of them, you may still find yourself down 10% or more in one day.
A daily-stop loss limit can help by limiting how much total money you can lose in one day. Typically, the limit shouldn't be more than about 3% of your account. If on any given day, you lose 3%, you stop trading for that day.
As you gain experience and develop a profitable track record, you can adjust your daily risk limit to be the equivalent of your average profitable day. By imposing the daily limit, any losses from a single day can be easily recouped by a typical winning day.
Lack of, or an Improperly Tested Strategy
Eager to get trading and making money, many new day traders read about a strategy, like how it looks, and so they jump in and start trying it out with real money. Others are a bit more cautious, and try demo trading the strategy first. If they make money with the strategy over a few trades, they start trading it with real money. Both of these approaches are likely to lead to disappointment in the future.
Successful day traders test out a strategy in all different types of market conditions and learn the strengths and weakness of a strategy before using it with real capital. They do this through demo trading--typically for at least three to six months (or more)--as well as looking through historical price charts and seeing how the strategy would have fared in various market conditions.
Before risking real money with a strategy, know when you should trade it and when you should stay away. Know how the strategy performs when the market is trending, ranging, whipsawing, when it is volatile and when it is calm. By testing your strategy against various market conditions, you'll be able to implement your strategy effectively when those conditions materialize.
Your broker is the biggest trade you will make. You are depositing all your capital with them, and yet many traders don't bother to research their broker until there is a problem.
Common broker problems include scam brokers, which are typically located outside first-world countries, although scam brokers can pop up anywhere. Scam brokers make it very hard or impossible for you to withdraw your money and any profits once you have sent it to them. Scam brokers typically don't last long and show up repeatably in forum complaints, so an online search should reveal any major problems with a broker.
A more subtle problem is slow quotes, or your broker is trading against you. Day traders need a direct access broker, where the broker's software sends the trader's order directly to the appropriate exchange. In day trading, every split-second counts, so if you place an order, you want it to get to the exchange instantly.
It's important to test your broker's software. A broker may offer great services, but if their software isn't good, it will be difficult to execute trades in a timely manner.
Research everything you can about a broker before sending your money to them. Trade a demo account with them for a few months, and test out their customer service. There are other factors to consider when choosing a broker, some of which are outlined in the 5 Steps for Finding a Great Forex Broker.
Let's face it, technology problems can happen to anyone. What happens if your computer crashes? Your internet goes down? Your power goes out? What if your broker's servers crash and you get disconnected from your broker?
There is no way for you to get out of a losing trade quickly if technology fails, which is why you need a stop-loss order in place on every trade.
Your broker's phone number should be programmed into a landline phone and a cell phone, so you can contact them quickly if needed. If your internet goes down, it may also be helpful to have a mobile version of your broker's trading platform on your smartphone. Your mobile internet might be operational if your computer crashes allowing you to manage your trades.
As a day trader, your profits and losses come from the orders you place. No matter what the price is doing, you should know your order types for getting in and out, both at a set price, called a limit order, and if you need to get in or out in a hurry, a market order.
You also need to know how to set stop-loss orders and profit targets, both for going long and short. Placing orders should be automatic, like flicking on the turn signal when changing lanes while driving.
If you don't know your orders types, your trading will be slow and clumsy, or you could place the wrong type of order, which will cost you money. Trading mistakes can happen, but compounding the mistakes with additional order-related mistakes is a recipe for disaster. Know your order types before you start trading.
Hidden Dangers in Day Trading — Yourself, Your Tendencies and Your Personality
As a new trader, another hidden danger is yourself. When starting out, day trading will be stressful, possibly infuriating, and will tax your mind in ways you didn't think it could. The markets are an endless sea of possibility; you can buy and sell at any time, and no one cares whether you win or lose (except you). This sort of freedom is dangerous and unnerving for most people, which is why most people who try day trading lose money.
When you start out, you don't know how you will react under various stresses. Will you abandon your trading plan? Will you choose not to implement your risk management strategy? Will you overtrade, or become too afraid to trade? Will you blame the market, and not take personal responsibility? Are you even able to stay focused for a couple of hour stretch while you trade? Many people think they can remain focused, but constant distractions keep them from trading effectively.
As much as possible, go through all the steps above to help minimize damage if you react negatively to the trading situation that may arise. Also, look critically at your personality. See where your shortfalls are, and work to build up these six critical trading traits.
Final Word on Knowing Just Enough to Be Dangerous
If you are starting out and have read a few books, watched some trading videos, and are dabbling in demo trading, you know just enough to be dangerous.
To help minimize the danger of losing money, implement a per-trade and per-day risk management strategy. Test and practice your strategy in diverse market conditions before using it with real capital. Don't take your broker for granted, as sending them money is one of the biggest trades you'll ever make. Technology is great, but it has drawbacks, too. Have redundant systems in place in case you get disconnected from your broker, and always have stop-loss orders on any open trade.
Know your order types so well that you don't need to think about them when stress levels are elevated. Finally, realize that the biggest danger to your capital is you since it's you who must implement and execute your trading strategy. Work on developing solid trader traits, and implement strategies for reigning in any problematic tendencies you notice in yourself.