The Day Trader - In part 1 of the Day Trader series we looked at the history and definition of the occupation of day trading. In part 2 we looked at the business of day trading and how to get started. In part 3 we now turn to the trading styles employed by day traders.
Day Trading: Part 3
Trading Styles and Methods
By definition day trading activity is almost entirely short term with trades opened and closed within the same day to minimise risk and by extension the cost in terms of margin.
Trading styles are categorised according to the time horizon that contains their analysis, execution and management.
The shortest of these time horizons is known as scalping. Scalping is when the trader enters and exits the market for any amount of gain without a limit placed on the size of the gain.
Scalping allows the trader to avoid any serious analysis and to concentrate on reactive trades based on immediate order flow. The scalper will tend to make a large number of trades with many small losses and gains. However, the scalper will have a reason to believe that the gains will outnumber the losses.
Most scalping strategies are better performed in direct access markets, where the trader can place, best bid and best offer limit orders as well as market orders.
A typical scalping strategy will involve a target profit of the same amount as the stop loss employed.
For investors and long-term traders, fundamental analysis is essential in the long-term time horizon as a way of determining valuation prospects.
However, for the shorter-term traders the assumption is that the market discounts all available news and data and reflects it in the price very quickly. This makes technical analysis a preferred form of short term analysis and forecasting.
As Technical analysis looks at price action and uses mathematical formula to support projections and forecasts it is very popular amongst day traders.
A more recent and effective form of analysis favoured by professional short term traders is the behavioural approach. This covers a range of techniques such as order flow analysis, tape reading and order book strategy.
Behavioural analysis focusses on identifying the sentiment and behavior of important trader groups in circumstances such as over an event, data release or indeed when popular technical analysis chart patterns form.
These trading strategies revolve around taking the opposite side to the crowd. It general means selling into rallies as they become exhausted. It would also mean buying into sell offs when they run their course. This type of strategy tends to be profitable in periods of directionless volatility.
As markets spend the greater amount of time moving randomly and without direction these strategies rely upon the popularity of breakout and trend following strategies.
Range trading is a popular strategy for contrarians, and in particular false breakouts of a range are used as triggers to trade against the false break direction.
Indicators like relative strength and slow stochastics are popular for contrarian trading styles
Trend Following Approaches
Trend following strategies are very popular amongst day traders even though the majority of trends take well over a day to develop. These strategies are popular with retail traders as they appear to promise the largest possible gains.
However, in reality trends take time to develop and a high number of potential trends stumble at the outset or experience several false breakouts of a trading range before finally beginning to trend. These false breakouts can prove costly for day traders as they can signal futile trade triggers.
To trade with the trend the day trader first has to identify the conditions that indicate that a market has shifted from a sideways range through a breakout phase and onto a trend. There are a number of indicators that can help with this based on moving averages.
Trading systems are also very popular with day traders. The idea is that past patterns will be repeated and that the introduction of strict trading rules and/or automated order entry can result in a robust method that eliminates the emotions and subjective nature of a discretional approach.
A system will contain a set of rules governing stop loss, target and trading size parameters. Signals for order entry and trade initiation will be generated according to a particular analysis method or combination of methods that will have been back tested to confirm a positive correlation of success.
Once the system is defined the trader will then decide whether to automate it or to apply it manually.
The Day Trader Conclusions
Day trading can be very profitable providing one picks the right market, tools and strategies. Those that work best for the day trader are not necessarily those that are the most popular for traders who have the luxury of holding overnight positions.