Day trading is high-frequency trading with the intention to profit off little changes in the prices of an asset without actually taking delivery of the asset. Trading positions are opened and closed on the same day.
It sounds like fun but when trading is done in a hurry, you are likely to make mistakes and bad decisions which can cost you money.
Day trading involves various securities including stocks, ETFs, bonds, forex as derivative products such as Contract for Difference (CFD), future contracts & option contracts.
Derivatives products are offered with leverage which entails taking a loan from your broker, to boost your trading capital. This can backfire if the market doesn’t move in your favor.
Most people want to day trade, because of TV adverts and social media chatter that “gamify” day trading, and paint a picture of a simple and easy path to wealth.
Whether you intend to day trade forex or Equity, there are five common risks you will have to deal with:
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Market Risk
Market risk is the probability that the market will move against you. This means that you could be wrong in your price speculation. You may speculate the price of an asset will go up, and it goes down instead. When that happens, it is said that the market has moved against you.
Markets could become volatile every now and then. The conflict between Russia and Ukraine has added to the volatility in today’s markets. Volatility means asset prices could fall to very low levels and rise to very high levels.
However as a typical day trader, you don’t have the luxury of time to wait for days for an asset price to rise. This is because you have to close your open positions that same day.
You end up selling at a loss so as to close your positions for the day, only for the price to skyrocket the next day. If only you had waited till the next day you would have sold at a profit. The point here is when markets are volatile, there is more risk and as a day trader, you could record huge losses.
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Leverage Risk
Leverage is a loan you take from your broker to help you increase your trading capital with the hope of maximizing profits. However leverage also multiplies your losses. It is expressed as a ratio like 1: 30 and this means for every $1 of yours, you can trade in assets worth $30.
If you want to buy 100,000 units of CFDs for EUR/USD exchanging at 1.08, the contract sum will be $108,000
And if leverage is 1: 100 it means you need to put down an initial margin (margin is inverse of leverage) of 1/100 or 1% of $108,000 which is $1,080 as security before the trade will be opened.
This implies that with $1,080 you can control $108,000 worth of currency. This is a huge risk for any inexperienced trader.
Should the exchange rate of EUR/USD fall by even 5%, you will lose $5,400 which is more than your initial investment of $1,080.
In the EU and UK, regulatory authorities like the FCA have capped leverage at 1: 30 maximum limit that CFD brokers can offer to retail traders, so as to prevent excessive investor losses & abuse, and all regulated CFD brokers in the UK must follow these leverage restrictions, and can only offer 1:30 leverage on forex to retail traders in the UK; the leverage is lower for other CFDs like crypto assets.
However, in some other geographies outside EU and UK, like in Africa & Asia, it is not uncommon to find CFD brokers who are ready to offer leverage as high as 1:1000 to traders. This puts beginner traders at even higher risk of losing from day trading.
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Counterparty Risk
This is the risk that your broker or some other counterparty to your trade (a party taking position against you to fill your order or the one providing liquidity) will fail to fulfil their obligation thus causing you to lose money.
Firstly your broker could be unregulated and operating without a license, or he could be regulated but operating outside the mandate of his license. You could lose money to a scam broker.
Secondly your broker could be a market maker. This means he acts as a counterparty to your trade so when you sell, he buys from you and when you buy, he sells to you. If the broker lacks integrity, they could manipulate the market prices to make you sell at a loss or buy at a high price.
Thirdly your broker could hunt your stop loss orders. They could manipulate the quoted prices to force the price of the asset down or up to trigger your stop price, then activate market order after which they turn around and buy from you or sell to you at manipulated prices, hence profiting from your loss.
There have even been reports of dubious brokers, mounting their servers in buildings near the stock exchange. They attempt to intercept & manipulate data from the stock exchange for their own nefarious activities.
For example in 2020, Robin Hood a popular “zero commission” brokerage, had to pay a fine of $65 Million to American market regulators after it was discovered customer orders were filled at inferior prices.
Market makers paid Robin Hood to direct customer orders to them and executed the orders at inferior prices thus costing the customers about $34.1 Million.
These customers patronized Robin Hood because of the idea of Zero commissions only to have their orders filled at inferior prices. The payment Robin Hood received is known as payment for order flow (PFOF) and this is an example of counterparty risk.
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Regulatory Tax, broker fees and commissions
Governments levy taxes on the sale of an asset. When you sell a stock or currency and make gains, you are obligated to pay short term capital gain (STCG) tax to your government. The tax is called short term because you held the asset for less than one year.
STCG is usually higher than long term capital gain (LTCG) which applies when you hold an asset for more than a year before selling.
If you are trading large volumes of currency, your forex broker will charge you commissions. Those who use high end accounts like silver accounts, Gold account etc. pay more commissions.
For example a broker could charge $7 per round trip for every standard lot (100,000 units) of currency traded. A round trip is when you buy and sell an asset. Another broker could charge $7 for every trip which will mean $14 for a round trip.
As a day trader you also need to pay for research, charts, signals etc. and all these cost money. You need these tools if you are going to be a serious day trader. If you trade with leverage/margin you could also be required to pay interest on the loan taken.
Day trading can be addictive and this has caused the US market regulators to move to discourage excessive day trading. They have tagged anyone who trades more than four times a day with a margin account as a Pattern Day Trader (PDT).
PDTs in the US are expected to always keep $25,000 in their margin account and risk having their trading accounts frozen for 90 days if they cannot meet margin call obligations.
As a day trader, excess fees and unfriendly government regulation can take a chunk out of any gains you may make.
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Risk of burnout/stress
Day trading with a demo account can seem like a game because real money and emotions are not involved. However live day trading can be a mix of emotions such as fear, and anxiety and this can be unenjoyable.
You find that you are secluded, spending a whole day monitoring the screen. Forex traders find themselves waking up at odd hours to trade at different sessions.
It is difficult to take a break because while you are resting that could be when something big is happening in the market. So the cycle continues and you keep watching your screens.
Not getting sufficient sleep can be extremely stressful and after all the stress, you could still end up making a loss.
Day trading also takes a toll on social and family life. You begin to miss out on social activities, vacations, family picnics etc. Stress is part of the reason why some traders commit suicide after recording losses.
Managing Risk
If you must be a day trader, you need to manage the risks you will face by making use of stop loss orders.
Stop loss orders are used to limit the total losses you could face should the market move against you.
By activating a stop loss order, you set a stop price for the asset being traded. Once this price is crossed, your broker will either buy or sell the asset for you at the next available price.
If EUR/USD is currently exchanging at 1.08, you could set a stop loss at 1.06 so that once the price drops past 1.06 your broker will sell off your EUR/USD position to prevent further loss.
Also, you must use risk management strategies like Risk to Reward ratio, and not risking capital more than what you are willing to lose.
Key Takeaway
Day trading is very risky and the rewards do not match the risk.
However, if you must day trade you should manage your risk and avoid illiquid stocks and exotic currency pairs. For example, in forex trading, the EUR/USD is the most liquid currency pair.
Investing for long-term in stocks and ETFs remains the safest way to get your money to work for you, as it is less stressful and less risky.
Interesting Related Article: “An Introduction to Stock Market Day Trading“
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