As of recently, I have begun to hear more from people who have decided to open self-directed brokerage accounts in an attempt to make money by placing short-term trades (or day-trade) themselves. For most of these people, this was the first time they have ever traded a financial instrument. But, boredom, market euphoria, and herd mentality are sometimes powerful forces that will inspire many people to enter the market and try their hand at trading. Thus, this month’s newsletter will address the topic of day-trading and provide some warnings to those that are new to trading. In addition, I will provide some resources for those that would like to learn more about trading and capital markets as a whole.
Recently, the stock market experienced a rare Black Swan event, which is an unexpected event that has unpredictable catastrophic consequences. COVID-19 was our Black Swan event that led to the market’s extreme sell off, which ultimately bottomed out on March 23, 2020. Since this market bottom in March, the S&P 500 index has gained more than 30 percent in less than three months. Historically, the S&P 500 market index has on average gained around 8% on an annual basis. In the last three months, the S&P 500 has returned about four times as much as its average annual return, producing a quicker market recovery than previous market crashes. There are a number of theories as to why there has been such a sudden surge in the market from its bottom in March.
One popular theory is that the market has seen a larger than usual influx of retail investors who are day-trading in the stock markets. Day-Trading is a form of short-term trading that usually uses technical indicators to decide when to buy and sell, typically holding a position for less than a 72-hour period. It is a very fast, active, high volume style of trading. Short term trading by definition is very different from investing, as investing is normally buying stock based upon a company’s fundamentals and prospective growth, with the intention to hold the stock for the long term. Traditional stock investing and portfolio management focuses on reducing risk by diversifying a portfolio’s individual stock positions by company, industry, and asset classes. In contrast, day-traders typically have little regard for diversification or company fundamentals in their trading. Instead, day-traders may use concentrated positions to take advantage of what they believe to be brief market mispricings, hoping to capitalize on market movements within a short period of time. It is understandable why someone would want to try their hand at day-trading. As of lately, the market’s volatility has been providing enough gains in a single day that would typically take an entire year to achieve during calmer periods. Unfortunately, this market volatility can also go the other direction and provide a year’s worth of losses in single day. With the volatility and risk in day-trading, most people who are day-trading should follow certain precautions.
If you have recently opened an investment account to day-trade or plan to open an investment account to day-trade, please be aware that there is substantially greater risk involved than in long-term investing. If you are attempting to trade leveraged financial instruments, options, or even use margin, your potential risk dramatically increases. Each of these investment instruments can not only increase your potential gains, but they can also increase your potential losses. Therefore, if you are going to day-trade, a good rule of thumb is to only risk an amount of money that you are comfortable losing. In addition, before you put any funds at risk, make sure that the other portions of your financial life are in order, by having appropriately funded emergency and retirement accounts. Having these other accounts in place should provide you with the stability to risk the money in your day-trading account. In order to hold yourself accountable, use a separate investment account for your day trading because it provides you a better ability to monitor your trades, gains, and losses. Finally, incorporate discipline. If you reach your predetermined limit or how much you can lose, stop. Study your mistakes and decide if you want to take the risk again. Then wait until you have saved enough beyond your emergency and retirement funds to be able to day-trade again.
Below are some additional resources and tips for those that plan on day-trading. Most importantly though, do not view this article as the end all of advice instead treat this article as a primer, because there is a lot to learn about trading and capital markets as a whole.
Type of Investment Accounts
Technical Indicators: Article 1 & Article 2