Day Trading Basics For Beginners – Lesson 2: How Day Trading Works

In this lesson I will review many of the basics of day trading and hopefully answer your questions about what day trading is and how it works. The lesson will also introduce some of the main tools and strategies that you’ll come across later in the book. As with any art form, tools are of no value unless you know how to use them. This post will be your guide in learning how to use these tools.

A compelling question to begin with is: What do you look for as a day trader?

The answer is simple. First, you’re looking for stocks that are moving in a relatively predictable manner. Secondly, you are going to trade them in one day. You will not keep any position overnight. If you buy stock in Apple Inc. (ticker: AAPL) today, for instance, you will not hold your position overnight and sell it tomorrow. If you hold onto any stock overnight, it is no longer day trading, it’s called swing trading.

Swing trading is a form of trading in which you hold stocks over a period of time, generally from one day to a few weeks. It is a completely different style of trading, and you shouldn’t use the strategies and tools that you use for day trading to do swing trading. Do you remember Rule 2, where I mentioned that day trading is a business? Swing trading is also a business, but a completely different kind of business. The differences between swing trading and day trading are similar to the differences in owning a restaurant and a food delivery company. They both involve food, but they are very different: they operate with different time frames, regulations, market segments and revenue models. You should not confuse day trading with other styles of trading just because the trading involves stocks. Day traders always close their positions before the market closes.

Many traders, including myself, do both day trading and swing trading. We are aware that we are running two different businesses, and we have gone through separate educational programs for the two kinds of trading. One of the key differences between day trading and swing trading is the approach to stock picking. I do not swing trade and day trade the same stocks. Swing traders usually look for stocks in solid companies that they know won’t lose their entire value overnight. For day trading, however, you can trade anything, including companies that will soon go bankrupt, because you don’t care what happens after the market closes. In fact, many of the companies that you day trade are too risky to hold overnight because they might lose much of their value in that short of a period of time.

You have now reached Rule 3 of day trading:

Rule 3: Day traders do not hold positions overnight. If necessary, you must sell with a loss to make sure you do not hold onto any stock overnight.

Buying Long, Selling Short

Day traders buy stocks in the hope that their price will go higher. This is called buying long, or simply long. When you hear me or a fellow trader saying, “I am long 100 shares AAPL,” it means that we have bought 100 shares of Apple Inc. and would like to sell them higher for a profit. Going long is good when the market is going higher.

But what if prices are dropping? In that case, you can sell short and still make a profit. Day traders can borrow shares from their broker and sell them, hoping that the price will go lower and that they can then buy those shares back at a lower price and make a profit. This is called short selling, or simply short. When people say, “I am short Apple,” it means they have sold short stocks of Apple and they hope that prices will drop. When the price is going lower, you owe 100 shares to your broker (it probably shows as -100 shares in your account), which means you must return 100 shares of Apple to your broker. Your broker doesn’t want your money; they want their shares back. So, if the price has gone lower, you can buy them cheaper than you bought them earlier and make a profit. Imagine that you borrow 100 shares of Apple from your broker and sell them at $100 per share. Apple’s price then drops to $90, so you buy back those 100 shares at $90 and return them to your broker. You have made $10/share or $1,000. What if the price of Apple goes up to $110? In that case, you still have to buy 100 shares to return to your broker because you owe them shares and not money. Therefore, you have to buy 100 shares at $110 in order to return 100 shares to your broker. In that case, you will have lost $1,000.

Short sellers profit when the price of the stock they borrowed and sold drops. Short selling is important because stock prices usually drop much more quickly than they go up. Fear is a more powerful feeling than greed. Therefore, short sellers, if they trade right, can make astonishing profits while other traders panic and start to sell off.

However, like anything in the market that has great potential, short selling has its risks too. When buying stocks of a company for $5, the worst case scenario is that the company goes bankrupt and you lose your $5. There is a limit to your loss. But if you short sell that company at $5 and then the price, instead of going down, starts going higher and higher, then there won’t be any limit to your loss. The price may go to $10, $20, or $100, and still there will be no limit to your loss. Your broker wants those shares back. Not only can you lose all of the money in your account, but your broker can also sue you for more money if you do not have sufficient funds to cover your shorts.

Short selling is a legal activity for several good reasons. First, it provides the markets with more information. Short sellers often complete extensive and legitimate due diligence to discover facts and flaws that support their suspicion that the target company is overvalued. If there were no short sellers, the price of stocks could unreasonably increase higher and higher. Short sellers are balancing the market and adjusting prices to their reasonable value. Their actions are conducive to the health of the market.

If the price is going to go lower, you may correctly ask, why does your broker allow you to short sell instead of selling stock themselves before the price drops? The answer is that the broker would like to hold their position for the long term. Short selling provides investors who own the stock (with long positions) with the ability to generate extra income by lending their shares to the shorts. Long term investors who make their shares available for short selling are not afraid of short term ups and downs. They have invested in the company for a good reason and they have no interest in selling their shares in a short period of time. They therefore prefer to lend their shares to traders who wish to make a profit from short term fluctuations of the market. In exchange for lending their shares, they will charge interest. Therefore, by short selling, you will need to pay some interest to your broker as the cost of borrowing those shares. If you short sell only during the same day, you usually will not need to pay any interest. Swing traders who sell short, usually have to pay daily interest on their short stocks.

Short selling is generally a dangerous practice in day trading. Some traders are long-biased. They only buy stocks in the hope of selling them higher. I don’t have any bias. I will short sell when I think the setup is ready, and I will buy whenever it fits my strategy. Having said that, I am more careful when I short stocks. Some strategies that I explain in Lesson 7 work only for long positions (Bull Flag and Bottom Reversal). Some strategies work only for short selling (Top Reversal) and others will work in both long and short positions depending on the setup. I explain these positions in detail in Lesson 7.

Individual traders, like you and I, are called retail traders. We can be part-time traders, or fulltime traders, but we’re not working for a firm and we’re not managing other people’s money. We retail traders are a small percentage of the volume in the market. On the other hand, there are Wall Street investment banks, mutual funds and hedge funds, the so-called institutional traders, and most of their trading is based on sophisticated computer algorithms and high frequency trading. Rarely is any human involved in the day trading operations of these large accounts. Through whatever means, institutional traders have considerable money behind them and they can be very aggressive.

You may correctly ask, “How can an individual trader, like you and me, coming later to the game, compete against institutional traders and win ?，’

The Achilles’ heel of most institutional traders is that they must trade, while individual traders are free to trade or to stay out of the market as they deem best. Banks must be active in the market and trade large volumes of shares at almost any price. An individual trader is free to wait for the best opportunities to arise.

Unfortunately, however, the majority of retail traders fritter away this fantastic advantage by over-trading. An individual who wants to succeed against the giants must develop patience and eliminate greed. The ultimate problem of losers is not their account size but their lack of selfdiscipline, over-trading, and their bad money management.

I always use the analogy of retail day trading and guerrilla warfare. Guerrilla warfare is an irregular approach to warfare in which a small group of combatants, such as paramilitary personnel or armed civilians, use hit-and-run military tactics, such as ambushes, sabotage, raids and petty warfare, to maneuver around a larger and less-mobile traditional military force. The United States military is considered to be one of the most formidable fighting forces in the world. However, they suffered significantly as a result of jungle warfare tactics used against them in North Vietnam. Earlier examples include the European resistance movements which fought against Nazi Germany during World War Two.

In guerrilla trading, as the term suggests, you are in hiding, waiting for an opportunity to move in and out of the financial jungle in a short period of time to generate quick profits while keeping your risk to a minimum. You don’t want to defeat or outsmart investment banks. You are simply waiting for an opportunity to reach your daily profit target.

As a retail day trader, you profit from volatility in the market. If the markets are flat, you are not going to make any money; only high frequency traders make money under these circumstances. Therefore, you need to find stocks that will make quick moves to the upside or to the downside in a relatively predictable manner. Institutional traders, on the other hand, are trading with very high frequency and will profit from very small movements of price, or as it is sometimes called, from a “choppy price action”.

It is extremely important to stay away from stocks that are being heavily traded by institutional traders. As an individual retail day trader, you must stick to retail trading territory. You will not trade stocks that other retail traders are not trading or not seeing. The strength of retail day trading strategies is that other retail traders are also using them. The more traders using these strategies, the better they will work. As more people recognize the line in the sand, more people will be buying at that point. This, of course, means the stock will move up faster. The more buyers, the quicker it will move. This is why many traders are happy to share their day trading strategies. It not only helps other traders to become more profitable, but it also increases the number of traders who are using these strategies. There is no benefit in hiding these methods or keeping them secret.

As part of the algorithmic trading by computer systems, the majority of the stocks will trend with the overall market unless they have a reason not to. So, if the market is moving up, the majority of stocks will be moving up. If the overall market is going down, the prices of the majority of stocks will also go down. But, remember, there will be a handful of stocks that will buck the trend of the market because they have a catalyst. I call these stocks Alpha Predators. I will explain them in Lesson 4 and describe how to find them. This is what retail traders are looking for – that small handful of stocks that are going to be running when the markets are tanking, or tanking when the markets are running.

If the market is running, and these stocks are running too, that’s fine. You just want to make sure you are trading stocks that are moving because they have a fundamental reason to move and are not just moving with the overall market conditions.

You may ask, what is the fundamental catalyst for stocks that make them suitable for day trading? Here are some examples:

Earnings reports
Earnings warnings/pre-announcements
Earnings surprises
FDA approval/disapproval
Mergers/acquisitions
Alliances/partnerships/maj or product releases
Major contract wins/losses
Restructuring/layoffs/management changes • Stock splits/buybacks/debt offerings

When I do reversal trades (Lesson 7), my favorite reversal trades are on stocks that are selling off because there has been some bad news regarding that company. If there is a quick sell off because of bad news, many people will notice and start monitoring the stock for what is called a bottom reversal. If stocks are trending down with the overall market, such as oil was some time ago, you cannot do a good reversal trade. Their value pops up by 10 cents, and you think it’s a reversal, but then they are sold off for another 50 cents. They’re selling off because they’re trending with both the overall market and their sector. Oil was a weak sector for a while and the majority of the oil and energy stocks were selling off. When a sector is weak, that is not a good time for making a reversal trade. That’s where have to differentiate.

So here’s the fourth rule of day trading:

Rule 4: Always ask, “Is this stock moving because the overall market is moving, or is it moving because it has a unique catalyst?”

That’s when you have to do a little bit of research. As you become more experienced as a trader, you will be able to differentiate between catalyst-based price action and general market trending.

As discussed, as a retail trader, you must be careful that you are not on the wrong side of the trade against institutional traders. But how do you stay out of their way? Instead of trying to find institutional traders, you find out where the retail traders are hanging out on that day and then you trade with them. Think about a schoolyard for a moment. You don’t want to be off in the sandbox doing your own thing, trading a stock that no one is paying attention to. You’re in the wrong place. Focus where everyone else is focused: focus on the stock that is moving every single day and receiving literally a ton of action. That is what day traders will be looking at. Can you day trade stock like Apple or Priceline or Coca-Cola or IBM? Of course you can, but these are slow moving stocks that are dominated by institutional traders and algorithmic traders, and in general terms they are going to be very hard to day trade. Think of it as the equivalent of hanging out in that isolated sandbox instead of hanging out with your peers in the playground where the cool cats are.

How do you determine what retail traders are focused on and your place in that playground?

There are a couple of ways to find your best place. One is by watching day trading stock scanners. I explain later in Lessons 4 and 7 about how I set up my scanner. The stocks that are gapping significantly up or down are going to be the stocks that retail traders are watching. Secondly, it’s good to be in touch with social media and a community of traders. StockTwits and Twitter are usually good places to learn what is trending. If you follow a handful of traders, then you’ll be able to see for yourself what everyone is talking about. There is a huge advantage to being in a community of traders, such as a chat room, and there are many chatrooms on the Internet.

As the reader of this post, you are welcome to join our private Kingtrader chatroom (www.Kingtrader.net). We have hundreds of traders and we are talking about what is hot today. If you’re trading completely on your own, you’re off in the corner of that proverbial playground. You’re not in touch with what other traders are doing, and inevitably you will make it really hard on yourself because you will not know where the activity is. I have tried blocking out social media and trading in a bubble, basically doing my own thing, and it did not work. Draw on the laws of high school survival to guide you!

A little more about what I do: As a day trader, I don’t trade based on the company’s fundamentals such as product, earnings, earnings-per-share growth and financial statements. I’m not a value investor and I’m not a long term investor. I don’t trade Futures either, but I do use Futures to gain an understanding of the overall market direction in the near-term future. I am also a swing trader. In swing trading, I personally do care very much about the fundamentals of the companies I choose to trade: their earnings, dividends, earnings-per-share, and many other criteria. But swing trading is not the focus of this post, so I won’t pursue that topic for now.

I’m also a FOREX (foreign exchange market) trader and sometimes I trade commodities and currencies. But in the mornings, I am mostly an equities day trader and I focus on the real stocks. The majority of day traders don’t trade penny stocks or on the over-the-counter (OTC) market. Penny stocks are extremely manipulated and they do not follow any of the rules of the standard strategies. We at www.Kingtrader.net trade real stocks. Sometimes we may be trading Facebook (ticker: FB) and sometimes we may be trading Apple (AAPL), but we will always be trading the stocks that are having a big day. You may be surprised, but on almost every single day in the market, there’s a stock having a big day because the company has released earnings, had a newsbreak, or had something bad or good happen to it. These are the fundamental catalysts that you must look for.

What does my day look like as a day trader? You will read about it in detail in Lesson 8, but a day in my life typically starts at around 6 a.m. (9 a.m. New York time) with pre-market scanning. I’m scanning to see where there is volume in the market. As early as 5:30 a.m., you’ll know what stocks are gapping up or gapping down. Then I start scouring through the news for catalysts that explain the gap. I start to put together a watch list. I rule some out and then I pick and choose which ones I do and don’t like. By 9:15 a.m. (New York time) I am in my chat room, going over my watch list with all of our traders. By 9:30 a.m., when the bell rings, my plans are ready.

From when the market opens at 9:30 a.m. until around 11:30 a.m. New York time, is when the market will have the most trading volume and also the most volatility. This is the best time to trade and to especially focus on momentum trading (which will be explained later). The advantage of having all of that volume is that it provides liquidity. This means there are plenty of buyers and plenty of sellers, which in turn means that you can easily get in and out of trades.

Around mid-day, you can have good trading patterns but you won’t have the volume. This means a lack of liquidity, which makes it harder to get in and out of stocks. This is especially important to consider if you want to take large shares. My focus has always been on trading at the market’s opening, which is 9:30 a.m. in New York (Eastern time). I personally trade only within the first one or two hours of the market’s opening. If you join the private chatroom that I mentioned above, you will see that I rarely make any trades after 10:30 a.m.

On a good day I have reached my goal by 7:30 a.m. Vancouver time (10:30 a.m. New York time) and I’m easing up. Often by lunchtime I’ve already hit my goal and I’m going to be sitting on my hands unless there is that perfect setup. From 4 p.m. until 6 p.m. I am in trading courses and we’re reviewing our trades from the day.

Why is the market at low volume during the mid-day and afternoon? Imagine you made $1,000 by 10 a.m. What are you going to do? Are you going to walk away with that profit or will you keep trading until you lose that money? Hopefully you will walk away. Many people are finished for the day at some point in the morning, and then they are going to go golfing or spend the rest of the day at their leisure. But, if they have lost $1,000 by 10 a.m., those traders are going to keep fighting it out to stay in the market. They’re going to keep trading, trying to make back what they lost. That means that mid-day trading is dominated by traders who have lost in the morning and are aggressively trying to regain their losses. That causes a lot of volatility, and not in a good way. That causes stocks to shoot up and down because people are going in and out with market orders. It’s this time of day that I consider to be dominated by more amateur traders and trading. Extrapolating from this, I go really easy at mid-day.

I avoid pre-market trading because there’s a very low liquidity as there are very few traders trading. That means stocks can pop up a dollar, then drop a dollar, and you can’t get in and out with large shares. You have to go really small, and you have to use such small positions that, for me at least, it’s just not worth it. If you don’t mind trading in only a couple of hundred shares, then you can certainly trade pre-market.

I live in Vancouver, Canada, so in my time zone the market opens at 6:30 a.m. (Pacific time). This means that my days start really early. The great advantage for me is that I can be finished trading before most of the people in my city are even out of bed. I can then spend the rest of my day skiing, climbing, with family and friends, or focusing on other work and the other businesses that I have. I try to hit my daily goal by 7:30 a.m. my time (which is 10:30 a.m. Eastern time) and then ease up. You know how easy it is to lose money. Once you have some money in your pocket, you should hold on to it.