What is Day Trading and How Does It Work?

If you’re thinking about a successful trading career, picking the right trading style is among the first important decisions you 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 is day trading and how it compares to the other major trading styles. We’ll also show you the main types of day traders and how they make their trading decisions to beat the market in intraday trading.

  • Day trading is a popular intraday trading style
  • Day traders 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
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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 you need to make sure to fully understand their requirements before choosing the one that suits you best.

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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 most retail traders, and position and swing trading require to leave your trades open for weeks or even months. That’s why the majority of retail stock and Forex traders are day traders, as day trading seems to provide the sweet spot between profitability and time required to analyze the market.

  • Day trading is a popular trading style that relies on intraday trading.
  • This means that day traders analyze the market on an intraday basis and make their trading decisions during the day.
  • Compared to scalping, day traders don’t need to stick 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 no 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 backtesting 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. Write down 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 forms. 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 mention 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 work over and over again.

All three principles, as will be shown in the following lines, apply to day trading.

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 single most important analytical discipline to master in order to become a successful day trader.

Breakout Trading

Breakout trading involves analyzing chart patterns and support/resistance zones in order to be prepared when a breakout occurs. The break of major price-zones leads to an increased momentum as stop-loss and take-profit orders are often placed around those levels. Breakout traders try to profit on the increased momentum by placing trades in the direction of the breakout. Trendlines, channels, horizontal support and resistance zones and chart patterns are the most commonly used tools by breakout traders. In the following chart, you can see an example of a breakout trade based on a wedge pattern.

As the chart shows, the break of the wedge pattern to the upside created increased buying pressure as buyers started to jump into the market. A breakout trader would place a buy position after the breakout and close his trade by the end of the trading day. This way, he or she isn’t exposed to overnight events which may disrupt the market and reverse the price.

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 its break will not remain unnoticed 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 it 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 long 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 the best friends of trend-traders, and Fibonacci retracements are also often used to measure the size of the corrections of intermediary and short-term trends. Unlike counter-trend traders which are explained next, 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 all mentioned trading types to find their trade setups.

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

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 is quite riskier 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 trade 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, i.e. the exit point. 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.

What is the Best Day Trading Type for You?

As explained above, each type of day trading has its own advantages and drawbacks. Among the mentioned day trading types, counter-trend trading is 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 breakout 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 even 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 mentioned day-trading types 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.

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Conclusion:

How to day trade

The process of day trading learning involves a lot of dedication and discipline. As your trading experience grows, you’ll 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 way 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 such as the major chart patterns, how to use channels and trendlines, and how to correctly identify support and resistance levels.

This article tried to answer the question of “what is day trading” by providing trade examples and explanations for each type of day trading. Day trading is 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.

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