Understanding the Risks of Day Trading

If you spent any time keeping up with the news last week, you likely heard of the day trading frenzy involving Reddit and the downtrodden video game retailer GameStop (GME). Like most media-fueled stock crazes, it ended badly for those who got in late, as GameStop shares plummeted by 80% shortly after topping the $400 mark.

The GameStop saga highlights the dangers of day trading, but it’s far from the first stock to suck in retail investors right before its bubble burst. With tax returns and stimulus checks hitting the bank accounts of many aspiring young traders, the market is full of froth, and many stocks are skyrocketing based on speculation. Day trading is a tempting path to quick riches, but it’s far more difficult than it seems. Understanding the risks of day trading is very important.

If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.

Pattern Day Trader Rules

The SEC has strict rules in place regarding day traders. In order to place more than three day trades in a five-day period (that’s a position opened and closed on the same trading day), you must have either:

  • A minimum $25,000 account balance
  • A cash account

Margin accounts with less than $25,000 in capital are permitted only three day trades per week. Many brokers will lock your account if you attempt a fourth day trade, which could result in you holding a position overnight that you really wished to sell.

Possibility of Heavy Losses

Day trading is extremely difficult. If stock prices were easy to predict, everyone would invest and the market’s returns would be whittled down to a pittance. Outsized profits are only possible if risk is present. For day traders, the risk of loss is a daily battle. You’ll need a mindset to withstand bad days and the ability to walk away if your strategies aren’t working.

Day traders need volatility to make profits, which usually means relying on small caps or low float stocks that move frequently and spastically. Risk management is crucial. You’ll need to know where your profit and loss thresholds are before entering the trade. Stop-loss orders are a must for day traders too to prevent cataclysmic losses on parabolic stocks.

Commitment, Dedication, and Practice at a Level Few Can Sustain

Day traders must give the market their full, undivided attention. You cannot be part-time day traders and expect to rack up wins. You’ll need to be in front of your computer screen during the entire market sessions, looking for opportunities and scanning for stocks that fit your criteria.

Most traders utilize some type of technical analysis to identify potential stocks to day trade. Whether it’s simple moving averages, volume analysis, or specific chart patterns, traders will look for technical indicators that signal a change in trend and pounce on the shares before the trend materializes. Many use sophisticated trading platforms and high-tech scanners to locate the best possible stocks. This is your competition in the day trading game. If you can’t bring yourself to this level of commitment, your run as a day trader will likely be short (and not profitable).

Scams and Stress

Day traders are looking for fast profits and scammers are always drawn to people looking for quick bucks. The day trading community is home to many “stock gurus” who charge membership fees for a chat room or newsletter. These “gurus” find small, low float stocks that can easily be moved with minimal volume and purchase shares. They then release their “hot stock pick” to the newsletter or chat room group. In classic pump and dump fashion, the stock rises and falls quickly, allowing the newsletter or chat room promoter to exit the stock with large wins while the paying members get table scraps. Remember, if a “successful” trader runs a paid subscription service, it’s likely because most of their income comes from subs, not winning trades.

Additionally, the life of a day trader is filled with stress. Volatile stocks can wear down even the most patient and prudent trader. Stress can make us tired, irrational, and prone to mistakes—like overtrading in an attempt to make up for a big loss. Plus, markets are now open from 4:00 a.m. to 8:00 p.m. EST for many traders. That’s 16 hours of reviewing stocks, looking for patterns, and stressing over positions. The goal of any day trader is financial freedom: to be your own boss and work your own hours. If that freedom comes at the cost of your physical and mental health, you may need to reevaluate your investment goals and philosophy.

Contact Good Life Financial Advisors of Mt. Pleasant

Understanding the risks of day trading is important! If you have any questions, reach out to a team member from Good Life Financial Advisors of Mount Pleasant for assistance.

Disclosure

The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.

Investing involves risks, including possible loss of principal. No investment strategy assures a profit or protects against loss.

The prices of small-cap stocks are generally more volatile than large-cap stocks.