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Day trading may seem like an easy path to wealth, but here’s what you should know before giving it a try.Image source: Getty Images.
When many people hear the term “day trading,” they get visions of people trading in and out of stock positions and making millions of dollars doing it. You may have even seen advertisements for day trading software programs, courses, and other products promising that you’ll be able to quit your job and make a living trading stocks.
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Let’s set the record straight here. Most day traders lose money. It’s not because they chose the wrong trading coach, read the wrong books, or anything like that. The reality is that as a day trader, the odds of success are simply not in your favor.
But we’re getting ahead of ourselves here. Here’s a definition of day trading, some of the reasons why becoming a profitable day trader is generally a losing battle, and the most certain path to wealth in the stock market.
What is day trading?
There are several possible definitions of day trading, depending on who you ask. For example, some people consider anyone who buys stocks with the hope that they go up over a relatively short period of time a “day trader.”
For our purposes, a day trader is someone who regularly buys and sells stock positions during the same trading day, hoping to capture a modest profit on each trade by selling the stock for slightly more than they paid.
As a simplified example, here’s the general goal of day trading. A day trader may identify a pattern in a stock’s price and buy 1,000 shares for $20. A few minutes later, when the stock moves up to $20.10, they might sell, resulting in a $100 profit on the trade. Day traders aim to produce several, or even hundreds, of this type of result each day.
The problems with day trading
On the surface, day trading may sound fun and exciting. After all, how difficult could it be to buy stocks, wait until they go up by a few cents, sell, and repeat the process?
As it turns out, earning profits by day trading is easier said than done. While there are many reasons that most day traders are ultimately not successful, here are five of the biggest reasons why the odds are stacked against new day traders.
Commissions can kill your profits
The first major problem with day trading is commissions. Sure, there are some brokerage platforms that offer commissions-free trading, such as Robinhood, but as a serious day trader, you’ll probably want an online broker that offers more advanced trading tools. For example, TD Ameritrade offers the highly-rated thinkorswim platform for active traders.
However, for a feature-packed brokerage account, you’ll have to pay commissions. Continuing with my TD Ameritrade example, the brokerage charges $6.95 commissions for stock trades.
Here’s why this is a problem for day traders. Let’s say that you execute an average of 15 round-trip trades in a day, meaning that you open and close this many stock positions in an attempt to earn small profits. Well, this means that you’re executing 30 trades in the average day, which adds up to $208.50 in commissions. Over the course of 250 trading days per year, this is $52,125.
The point is that your trades will need to earn a profit of $52,125 just to break even. In other words, you could actually be right more often than you’re wrong and sell your stocks for a total of $50,000 more than you paid for them and still lose money.
Bid-ask spreads put the odds in the house’s favor
In addition to having to overcome the commission obstacle, day traders are already at another disadvantage in the form of the bid-ask spread.
If you aren’t familiar, the stock price you see quoted when you look up a stock price is simply the price of the last executed trade. In reality, stock prices are a bit more complex and are based on what is referred to as the bid-ask spread.
Here’s how this works. The bid is the highest price someone is currently willing to pay for a certain stock. The ask is the lowest price someone is willing to sell a certain stock for, and is generally a few cents higher than the bid price. The more actively-traded a stock is, the narrower the gap, but there’s still going to be a bit of a spread no matter how popular the stock is.
As a real-world example, the current quote for Tesla stock shows a price of $369.24 as I write this, meaning that this is the price at which the last executed trade was made. Looking a bit deeper, I see that the current bid price is $369.11 and the ask is $369.50. What this means is that the lowest you can realistically expect to pay for the stock right now is $0.39 greater than anyone is willing to buy it from you for.
In other words, if you buy Tesla stock as a day trade in this scenario, you’ll need the bid price to rise by $0.39 just to break even when you sell. You’re effectively starting at a loss that will need to be overcome before you start making a profit.
To be thorough, this is a simplified example. As a day trader, you can offer a slightly more favorable price than the current ask price and can enter an order to sell for a slightly higher price than the current bid. And, there’s a good chance that your orders would be executed. Nevertheless, the general way the market works is that there’s still a gap that needs to be overcome between what buyers are willing to pay and what sellers are willing to accept.
Even if you make money, taxes can be brutal
For the sake of this discussion, let’s say that you overcome the inherent disadvantages of commissions and bid-ask spreads that I already discussed, and that you manage to earn a profit from day trading stocks.
Now, you’ll have to pay taxes on your profits. Day trading income meets the IRS’s definition of a short-term capital gain, so it is taxed as ordinary income. This can be an especially large problem if you are day trading in addition to other employment, as your day trading profits could potentially catapult you into a higher tax bracket.
A trader’s emotions can be their worst enemy
Human beings are emotional creatures. And unfortunately, our emotions are not necessarily wired for successful stock trading.
Here’s the problem. When stocks are going up and have lots of momentum behind them, it’s human nature to try to get in on the action and throw money into the market. Conversely, when things start to turn sour and stocks are falling, human nature tells us to get our money out before things get any worse. In other words, it’s common knowledge that the point of investing is to buy low and sell high, but our instincts tell us to do the exact opposite.
This discussion is about individuals who want to day trade. There are certainly traders who work for big Wall Street firms that are consistently profitable.
In fact, one of the problems with trying to day trade from home or at a trading center is that the big players on Wall Street simply have a massive technological advantage over you. They have the ability to react more quickly to market moves, and you aren’t likely to detect patterns or irregularities better than some of their algorithmic trading systems can, even with the best trading platforms offered by online brokers.
Think of it like this. If you’re a phenomenal driver, you wouldn’t try to drag race a Ferrari against a minivan. Your talent isn’t a big advantage if you’re working with inferior technology.
Most day traders lose money
Between these factors, day trading is like gambling in a casino. Even if you master your emotions, the odds are definitely against you, and over time your disadvantage gets tougher and tougher to overcome.
Four university professors published a research report in May 2011 in which they analyzed long-term day traders’ success rates. They found that in any given year, only about 13% of day traders earn any profit. What’s more, less than 1% of day traders are consistently profitable year after year.
The most certain way to make money in the stock market
Fortunately, there is a time-tested way to make money with stocks, but it’s not day trading. Long-term, buy-and-hold investing is by far the most surefire path to wealth.
With a solid long-term investing strategy, you aren’t going to double your money in a few months, and you probably won’t be able to quit your job and live off of your profits anytime soon. However, over time the results can be quite impressive.
Consider that the S&P 500 index has historically averaged annualized total returns of 9%-10% over long time periods, depending on the exact range of years you’re looking at. Based on the midpoint of this range, 9.5%, if you were to invest $5,000 in a basic S&P 500 index fund 30 years ago, and you added another $5,000 to your investment each year, you’d be sitting on a nest egg of nearly $750,000 today. And that’s if you simply matched the market’s performance.
If you’re thinking about getting into the stock market, I strongly encourage you to consider opening an account at an online brokerage and adopting a buy-and-hold investment strategy. Leave day trading to the professionals.