Day trading tends to be very popular when the market surges (e.g. the dot-com bubble or the cryptocurrency bubble). This is because everyone and their grandmother can make money trading when the market is going up. But it’s when the market’s going down that separates the truly skilled day traders from the beginners.
In this post we are going to look at:
- What is day trading
- What are its advantages and disadvantages.
- How we can improve on day trading’s disadvantages.
What is day trading
Day trading is a strategy whereby the day trader makes multiple trades each day.
- The position size for each trade is small, usually less than 5%. Each position size MUST be small because the trader has so many different positions.
- Each trade only lasts a few hours or a few days. Hence, the time frame for a day trader is very short.
- Each trade will only make small profits since the position size is so small and the time frame is so short. The day trader makes money by adding up profits across hundreds if not thousands of trades each year. This is akin to picking up a million nickels.
For one reason or another, day trading is seen as a “full time job”. The day trader is glued to his or her computer screen all day, from the opening bell to the closing bell.
Many people choose to become day traders for different reasons:
- Day trading is alluring because of the market’s short term and intraday fluctuations. Traders dream of “vast profits” if they can capture each and every one of those short term fluctuations.
- Day trading tends to be a steadier source of “income” as opposed to medium-long term trading. Day traders tend to have more consistent returns because they don’t hold any position for a long period of time. The longer you hold your position, the more likely you are to experience a massive gain or a massive loss.
Day traders can use a discretionary approach or a quantitative approach.
Discretionary day traders either use price action or standard technical analysis to trade:
- Day traders who use price action are intune with the “feel” of the market. The day trader will go short if the market “feels” weak. The day trader will go long if the market “feels” strong. This is generally not the best way to day trade because the market will generally “feel” strong when it’s going up and “feel” weak when it’s going down. Remember, trading on your gut feeling is rarely a good idea.
- Day traders who use standard technical analysis use trendline support/resistances (e.g. moving averages), patterns, and contrarian indicators like RSI. They essentially buy on support, sell on resistances, buy on breakouts, sell on breakdowns.
Others employ a quantitative (systematic) approach to day trading. This is what I do with the Day Trading Model. Day trading models allow the trader to backtest certain indicators for the optimal BUY and SELL signals. In addition, models allow the trader to backtest certain risk management strategies.
What are the advantages and disadvantages of day trading
Some people decide to become day traders due to the advantages that day trading has over trading strategies with longer time frames. If done properly…
- Day trading leads to lower risk
- Day trading leads to more consistent returns, almost like an “income stream”.
- Day trading is more suitable for periods of high market volatility.
Day trading leads to lower risk
Successful day traders spread their capital across multiple small positions. For example, a common rule of thumb is “don’t risk more than 5% of your portfolio on any single position”. Another rule of thumb for day trading is “always hold at least 5 different positions”.
This is essentially diversification at its most extreme. Holding only one position can be dangerous because you have all your eggs in one basket. Random and unpredictable events can dramatically hurt your portfolio because of a lack of diversification.
For example, let’s assume that most of your capital is tied up in Facebook. You would have lost a lot of money when the Cambridge Analytica scandal came out. Facebook immediately cratered, and traders who held too much Facebook would have been hurt the most.
Day traders dramatically lower their risk by holding at least 5 different small positions. Day traders will frequently go long and short at the same time, which means that at least one side of their portfolio will always be making money. For example, let’s assume you were long Facebook, long Google, long Apple, short Amazon, and short Netflix when the Cambridge Analytica scandal came out. You would have lost money on the 3 long positions (Facebook, Google, and Apple) but made money on the 2 short positions (Amazon and Netflix). The gains from your short positions will offset some of the losses.
This is something that you can see in our Day Trading Model vs our Medium-Long Term Model. The Medium-Long Term model produces higher average returns, but it also has higher short term risk. This is because the Medium-Long Term Model only holds a single position (SSO or UPRO) for a rather long period of time. If that single position loses money, the entire portfolio will lose a significant amount of money for a period of time.
On the otherhand, the Day Trading Model produces lower average returns, but it also has less short term risk. The Model often carries 10-15 different positions at a time, which means that each position’s size is usually between 2-5% of the total portfolio. This means that a big loss in one position will have a relatively small impact on the overall portfolio.
Day trading leads to more consistent returns.
Day trading does not allow you to maximize long term performance. In order to maximize long term performance, you must swing big for home runs. That’s what we do with the Medium-Long Term Model. We want to ride the bull market’s rallies as much as possible, and when we do we use leverage to magnify our returns.
Day trading is different. It’s like picking up a thousand nickels every year. Each trade yields a small profit or loss, but those small profits will hopefully add up to a decent return at the end of the year.
Day trading is more consistent because you only hold each position for a very short period of time.
Here’s what the returns look like for day trading vs. medium-long term trading. The upper red line represents day trading. The lower red line represents medium-long term trading.
For example, we can achieve an average annual return of 45% with the Medium-Long Term Model. But this strategy means that we can be down -10% or -20% in a month. As you can see, the short term fluctuations in the Medium-Long Term portfolio are massive.
On the otherhand, day trading yields a lower annual return but more consistent profits. For example, we might be up 1% this month, up 2% the next month, down -1% the next month, up 3% the next month, etc. Smaller position sizes and a greater number of different positions smooths out the day trading portfolio’s monthly returns.
This is also why many smaller hedge funds use short term or day trading strategies. Their clients want to see consistent and smooth monthly returns (e.g. 1-2% each month). They don’t hold big positions, so no single loss is going to sink their annual returns.
Day trading is suitable for periods of high market volatility
Day trading is a decent trading strategy, but it’s exceptionally suitable for periods of high market volatility. Day trading is not very suitable when the stock market’s volatility is very low (i.e. it trends strongly) because you miss out on too much of the trend by jumping in and out of the market. This was the case in 2017.
- Traders who held their positions for long periods of time made the most money as the rode the entire rally on its way up.
- Day traders who jumped in and out of the market made less money because they missed out on some of the rally.
Exceptionally strong trends are even worse for day traders who go both long and short. It doesn’t matter how good your “trading skills” are. You will lose money on one side of the market if the trend is too strong. For example, day traders who went long and short in 2017 inevitably lost money on their short positions. The stock market hardly made a single pullback in 2017.
On the otherhand, day trading is exceptionally profitable when the market is highly volatile, like the stock market from 2015 to early-2016. This is exceptionally true for day traders who go both long and short: they will make money on both sides of the market.
- The day trader shorts. The market goes down, he takes his profit.
- The day trader goes long. The market goes up, he takes his profit.
Here’s the secret about day trading when the market is very volatile: you can still make money even if your entry price isn’t very good! Since the market is swinging sideways with a lot of volatility, you will make money on almost every single position AS LONG AS you hold that position long enough! Losses will turn into profits! Just hold a position that’s losing money until it becomes profitable. The market is swinging sideways with a lot of volatility, so the market is bound to at least reconnect with your entry price at some point.
Day trading’s disadvantage
Day trading’s main disadvantage is that most day traders have a very poor understanding of the market’s medium-long term trend. Understanding the long term trend is important because:
- The market goes up more often than it goes down when the long term trend is UP. There is a bullish bias, which means its easier to make money on long positions.
- The market goes down more often than it goes up when the long term trend is DOWN. There is a bearish bias, which means its easier to make money on short positions.
Hence, day traders need to have an accurate understanding of the market’s long term trend.
- When the long term trend is UP, day traders should put on more long positions than short positions. The long positions will probably make money. The short positions will either lose money (if your timing is wrong) or make a little bit of money (if your timing is right).
- When the long term trend is DOWN, day traders should put on more short positions than long positions. The short positions will probably make money. The long positions will either lose money (if your timing is wrong) or make a little bit of money (if your timing is right).
Day trading against the long term trend is a cardinal sin. You want to trade on the side of the long term trend because it’s easier. Trading against the long term trend is just asking for trouble.
How can we improve on day trading’s disadvantages
As we mentioned already, day trading’s biggest disadvantage is that you will lose money on your trades that go against the long term trend.
The improper thing to do is ONLY trade on one side of the market – the side of the long term trend. You will lose money on all your positions if the market makes a medium term counter-trend move (e.g. makes a correction in a bull market) and you only trade on the long term trend’s side. That’s why you should go both long and short in your portfolio. If you trade both sides of the market, at least you will always have some winners regardless of which way the market swings.
What you should do is set a target net long %. This is what we do with the Day Trading Model.
First, decide if it’s a bull market or a bear market right now:
- If it’s a bull market, always have more than 50% of your positions be long positions.
- If it’s a bear market, always have less than 50% of your positions be short positions.
Then decide if you’re bullish or bearish on the market’s medium term outlook. If it’s a bull market…
- If you’re bullish on the medium term, hold e.g. 80% long positions and 20% short positions.
- If you’re bearish on the medium term, hold e.g. 55% long positions and 45% short positions.
If it’s a bear market…
- If you’re bullish on the medium term, hold e.g. 45% long positions and 55% short positions.
- If you’re bearish on the medium term, hold e.g. 20% long positions and 80% short positions.
Then adjust the TARGET number of long positions and TARGET number of short positions according to how bullish or bearish you are on the medium term. The more bullish you are, the more long positions you should hold. The more bearish you are, the more short positions you should hold.
Once you determine your target net long holdings, long the stocks that you think are “stronger” and short the stocks that you think are “weaker.
Divide your position sizes and signals into MIN, MEDIUM, and MAX
Day trading’s other big problem is that you can’t make massive returns when the market is trending very strongly or when your conviction on a trade is very strong. Here’s what you should do to partially solve this problem:
Create MIN, MEDIUM, and MAX signals
This means that you should assign every trade a rating.
- Assign MIN to trades you that have a relatively low degree of conviction in.
- Assign MEDIUM to trades that you have a decent amount of conviction in.
- Assign MAX to trades that you have a high degree of conviction in.
Structure your position sizes accordingly. The more conviction you have in a trade, the bigger that position for be. For example.
- Trade with 2% of your portfolio on a MIN position.
- Trade with 4% of your portfolio on a MEDIUM position.
- Trade with 8% of your portfolio on a MAX position.
This ensures that you will better take advantage of trades that truly believe in.
Day trading can be extremely tiring
Day traders typically stare at their computer screens all day from the opening bell to the closing bell. This is a terrible lifestyle, and it becomes exceptionally hard the older you get.
That’s why it’s better to create a quantitative model for placing day trades. You will spend time on building and improving your model, but at least you can do this whenever you have time. Then you can just let the model trade on its own once you’ve built the day trading model. You don’t need to be glued to your computer screen all day.