What is Day Trading and How Does It Work?

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10 min read minutes read/Updated: 11.10.2019

If you’re thinking about a successful trading career, picking the right trading style is among the first important decisions you will need to make. Your trading style will ultimately determine your approach to trading, the time frame on which you’ll place your trades and how often you need to manage them afterwards.

This article is going to provide you with an in-depth explanation of what day trading is and how it compares to the other trading styles. We will also show you the main types of day trading and how trading decisions are made.

  • Day trading is a popular, intraday (within the day) trading style
  • Day traders might base their trades on; trend-following, counter-trend or breakout strategies
  • Technical analysis is the main analytical tool for day traders
  • Fundamentals – except major news and reports – are often dismissed

What is Day Trading?

There are four major trading styles to trade on the financial markets – scalping, day trading, swing trading and position trading. All of them have their distinctive advantages and drawbacks, and beginner traders will need to ensure they fully understand the requirements of each different style before choosing the one that suits them best.

What is Day Trading?

Scalping – which involves opening a large number of trades on very short timeframes – is a very intense and fast-paced trading style that doesn’t fit in the schedule of many retail traders, whereas position and swing trading requires trades open for multiple days, weeks or even months. That is why the majority of retail Stock, Forex and Commodity traders are day traders, as day trading seems to provide the sweet spot between profitability and time required to analyse the market.

  • Day trading is a popular trading style that relies on intraday trading.
  • This means that day traders analyse the market on an intraday basis and make their trading decisions during the day.
  • Compared to scalping, day traders don’t need to stay rigidly in front of their trading platform for hours during the day.
  • This means that day traders can also have a regular day job and still be able to trade.

Day Traders Don’t Need to Spend Hours in Front of the Screen

Most day traders will pick a direction for the market early in the morning and close all of their trades by the end of the trading day. There is not necessary a definite need to actively manage the trades during the day, so day traders still have enough time for other activities, which is a huge advantage of this trading style.

How long the process of day trading learning takes depends on the dedication and effort that you put in the process. You can save some time by back testing potential trade setups with historical price data and see how they would play out. However, the real experience comes when you start placing real trades.

Day traders usually start looking for trading opportunities the evening before they place their trades. Look at the financial instruments which show trading potential, check the economic calendar to see if there are major reports scheduled for the upcoming day, and you’re ready to place your trades when the trading opportunity arises. Keep in mind that major news may create significant volatility in the market, so either don’t trade around major reports or account for the volatility with wider stop-loss levels.

Types of Day Trading and Technical Analysis

There are three main types of day trading – breakout trading, trend trading and counter-trend trading. As this is an intraday trading style, all of the aforementioned types rely primarily on technical analysis techniques to identify potential trading opportunities.

Technical analysis relies on three basic premises:

a) Markets tend to trend – once a trend is established, there is a higher chance that it will continue than reverse.

b) Price discounts everything – all available market information is already included in the price, which makes the price-chart your most important tool.

c) History tends to repeat itself – market participants are humans with emotions, and chart patterns which explain the underlying market psychology have a tendency to repeat over and over again, over time.

Trend-following day traders base their trade setups on trends, while breakout traders use chart patterns that worked well in the past and assume that they will work as well in the future. As you can see, you should incorporate the study of technical analysis early in your day trading learning process. In fact, technical analysis is probably the single most important analytical discipline to master in order to become a successful day trader.

Breakout Trading

Breakout trading involves analysing chart patterns and support/resistance zones in order to be prepared when a breakout occurs. The break of major price-zones often leads to an increase in momentum and volatility as stop-loss and take-profit orders are often placed around these zones. Breakout traders try to profit on the increased volatility by placing trades in the direction of the breakout. Trendlines, channels, horizontal support and resistance zones and chart patterns are the tools most commonly used by breakout traders.

Trendlines are also a great tool for breakout traders. When drawing trendlines, make sure that the price has touched the trendline at least three times before. This will make sure that the trendline has significance and that any break will be noticed by other market participants (i.e., buyers or sellers will enter the market).

Trend Trading

Trend trading is another popular type of day trading. As the name suggests, trend traders look to enter the market in the direction of the overall trend. Trend-trading has a proven track-record as markets have a tendency to trend for a notable period of time. However, one thing you need to pay attention to is the timeframe you use to identify the trend. What looks like a downtrend on a 1-hour chart, may in fact be an uptrend on the 4-hour or daily charts. In essence, longer timeframes are more reliable for trend traders than shorter ones, so make sure to know the main classifications of trends (primary, intermediary and short-term), so you don’t fall in the trap of opening a counter-trend trade in the wrong direction.

Primary trends are the main trends in the market that usually last from 9 months to 2 years. While this time horizon may be out of your interest, you still need to be aware of what the primary trend is in the instrument you want to trade.

Intermediary trends are corrections of primary trends and usually last up to a few weeks. You can identify intermediary trends on the daily and 4-hour charts. And finally, short-term trends can take any direction and can be spotted on relatively short timeframes. As a day trader, you’re most interested in the short-term trends as they are what you’ll be trading on.

High-Probability Trend-Following Trade Setups

Trend-following trade setups with the highest success rate emerge when the intermediary and short-term trends overlap, i.e. the short-term trend turns in the direction of the intermediary trend. This is especially true if the intermediary trend also turns in the direction of the primary trend, although those trade setups may take some time to develop.

Again, trend lines and channels are very useful tolls for trend-traders, whilst Fibonacci retracements are also often used to measure the size of the corrections of intermediary and short-term trends. Unlike counter-trend traders (see below), trend-traders take trades only in the direction of the underlying trend and dismiss short-term market corrections.

At this point, let’s underline the difference in the entry points between breakout traders and trend traders again. While a breakout trader would wait for the trendline (or other technical level) to break before entering the trade, a trend-following trader waits for the price to bounce off the trendline instead. Both approaches can be used to identify profitable trading opportunities, and the approach a day trader would take typically depends on the current market environment. Day traders often combine the differing trading types to find their trade setups.

A typical trade based on trend-trading is shown on the following chart.

High-Probability Trend-Following Trade Setups

Counter-Trend Trading

Unlike trend trading which involves opening trades in the direction of the overall trend, counter-trend trading has the opposite objective – to capture moves which go in the opposite direction of the main trend. It’s important to emphasize that this technique usually carries higher risks, compared to breakout trading and trend trading. However, with the right approach, counter-trend trades can have a success rate close to the other types of day trading.

Basically, counter-trend traders place trades on the corrections of the major trend. According to the Dow theory, the size of the correction should be around 50% of the primary move, and counter-trend traders often use the Fibonacci tool to measure the extent of a correction.

Counter-trend traders need also to know the difference between a trend reversal and a trend correction. A reversal is characterized by the price failing to make a higher high during an uptrend, or a lower low during a downtrend. A correction, on the other side, is a short-lived move in the opposite direction of the underlying trend, which doesn’t have to lead to a fresh higher high or lower low.

On the following chart, corrections are marked with the solid red lines, and Fibonacci retracement levels are applied to the chart to measure the extent of the correction. Counter-trend day traders would look to short the financial instrument and capture the fall in the price (or rise during downtrends) during a market correction.

How to day trade

What is the Best Day Trading Type for You?

As we have looked at, each type of day trading has its own advantages and drawbacks. Among the aforementioned day trading types, counter-trend trading can be viewed as the riskiest approach, as it involves opening trades in the opposite direction of the underlying trend. Trend-trading and breakout trading are less risky and have a proven track record, but keep in mind that you need to catch the breakout as soon as it happens as the initial momentum is where the largest profit potential lies.

Trend-following trades can take a longer period of time to develop, and you need to take into account the short-term corrections which may happen while your trade is still open. Still, markets like to trend and this approach can generate plenty of high-probability trade setups if you follow the rules correctly. As said earlier, the assumption that markets spend most of their time in trends is one of the basic premises of technical analysis, and this type of analysis is the primary tool of day traders considering their relatively short-term approach to trading.

Keep in mind that many day traders combine the different day-trading types in order to increase the number of potential trading opportunities. As you start the day trading learning process, you’ll naturally identify which day trading type suits you best.

How to day trade

Learning day trading involves a significant amount of dedication and discipline. As a traders experience grows, they will find it easier to spot potential trade setups – whether they are based on breakouts, trend-following or counter-trend trading.

Day trading is arguably the most popular trading style among retail traders, as it is not as time consuming as scalping, but still offers more trading opportunities than swing trading or position trading. To become a successful day trader, you need to learn the basic tools of technical analysis including the major chart patterns, how to use channels and trendlines, and how to correctly identify support and resistance levels.

This article has tried to answer the question of “what is day trading and how does it work” by providing examples and explanations for each type of day trading. Day trading is an art as much as it is science, because day traders need to able to correctly identify major technical levels which are followed by other market participants as well. Only when a technical level is considered important by other traders, will the break of or bounce off it create enough momentum to make for a profitable trade. Happy day trading!