Investing

The Dangers of Day and Swing Trading

Are you an investor or a trader? If you are a trader, you tend to move in and out of positions as quickly as possible, taking small profits or losses when you can rather than waiting for several weeks to pass.

Day trading and swing trading are highly speculative, but still appeal to many traders and for several reasons. A day trader strives to open and close positions within one trading session so that at the end of the day nothing remains open. The advantage to this is that there is no danger of losing due to big after-hours moves in price.

Swing trading is quite different. A swing trader opens positions when the price moves quickly in one direction and is expected to swing back the other way. This is based on the fact that markets over-react to almost all news and information. So a disappointing earnings report may cause a stock to fall four points, but over the next one or two sessions, it moves back up three points. Swing traders try to recognize these opportunities, open positions for two to five days, and then take profits.

No novices need apply

These are appealing strategies because profits can be made very quickly, often in only a matter of hours, or even minutes. But losses can happen rapidly as well. Day trading and swing trading are not strategies for novices. The entry and exit signals are complex and often subtle, and successful day traders and swing traders usually rely on years of trading experience.

One of the caveats about active trading is a restriction on how often you can legally move in and out of positions on the same security. A “pattern day trader” is anyone who buys and sells the same security four or more times in five consecutive trading days. Anyone meeting this definition is required to keep at least $25,000 in cash and securities as a minimum margin requirement. The purpose is to offset the problems of the past in which day traders could execute millions of dollars without any margin balance at all. This is possible because margin requirements are calculated as of ending balances open each day; and day traders close everything before the market closes.

Spreading the risk

The risks are not limited to high margin requirements for active trading. More important are the capital risks involved in short-term trading. The direction of securities is going to be very uncertain in the short term. So even when you recognize a classic buying or selling opportunity, your timing is never going to be perfect. Unless you spread the risk among several different positions, you could lose a lot very quickly. Dozens of profitable trades could be wiped out with one poorly timed trade if the levels of risk are not managed well.

Smart traders know how to spread risks. They also know that no one is going to have profits 100 percent of the time. The smartest traders know something else: High-risk strategies produce dazzling profits some of the time, but they also produce dazzling losses the rest of the time.

Michael C. Thomsett is author of over 60 books, including Annual Reports 101 (Amacom Books Press), Trading with Candlesticks (FT Press) and the recently released new book, Getting Started in Stock Investing and Trading (John Wiley and Sons).  He lives in Nashville, Tennessee and writes fulltime.