Friday, October 2, 2009

Day Trading

Here are some of the important terminologies of Day Trading. You need to go through that.

Securities: Financial assets that can be assigned value and traded. Typical securities include stocks and bonds.

Derivative: A dependent security whose price is derived from one or more underlying assets and whose value is determined by fluctuations in the underlying asset. Futures contracts are a common type of derivative.

Stock: A type of security that gives the holder ownership rights in a corporation. If you own a company's stock (or own shares), then you are a shareholder.

Index: An imaginary portfolio of securities representing a particular market or a portion of it. The Standard & Poor's 500 is a well-known index.

Trade: To buy or sell financial assets in any of the financial markets.

Trader: A person who buys or sells financial assets for himself or for others. Traders generally hold assets for a much shorter time than investors.

Broker: A middleman who facilitates trades between buyers and sellers.

Leverage: The use of borrowed money to increase potential returns.

Initial Public Offering (IPO): The first sale of a corporation's stock. Such a company is said to be "going public."

Liquidity: The ability to buy and sell an asset without affecting price levels.

Volatility: A measure of how much the price of a security will vary over time.

First, let's be clear about what day trading isn't. It's not investing, which is the process of buying a stake in an asset that will hopefully build a profit over the long term. How long is subjective, but investors generally hold assets for years, even decades. And they're usually concerned with the businesses they invest in. They look for companies that make solid profits, pay off debts in a timely manner, have a strong pipeline of products and avoid litigation.

day trading
Image courtesy William Harris
This chart shows the extremes in investment horizons.­

Day trading, on the other hand, involves buying and selling securities within the same day. Day traders often use borrowed money to take advantage of small price movements in highly liquid stocks or indexes. In general, they follow the same wisdom as longer-term investors: They try to buy low and sell high -- they just do it in a very compressed window of time.

Important markets for Day Trading are Dow Jones, NASDAQ, Nikkei and some more.

Here are some of the strategies for Trading

If you'll recall, leverage is the process of borrowing money to make more money.

Let's say a particular trade results in a 10 percent return. If you have $50,000 in your account, then your return will be $5,000. But if you borrow another $50,000 and add it to your account, then your return doubles -- you make $10,000. Leverage enables you to increase the dollars returned to you without increasing the performance of the trade.

Where do day traders find this money? They generally borrow it from their brokerage firms, using a special account known as a margin account. The margin account is different from a trader's cash account and requires an initial investment of at least $2,000. Once the margin account is opened, a trader can borrow up to 50 percent of the purchase price of a stock. This is also known as buying on margin.

Another borrowing strategy is selling short. A day trader who sells short borrows a security and then sells it in the hopes of repaying the loan by buying back cheaper shares later on. In this case, the trader looks for a security that is going down in price (as opposed to the more common practice of buying low and selling high). Once he identifies such a security, the trader:

  1. Places an order to sell the stock
  2. Tells the broker he does not own the shares, but instead wants to borrow them
  3. Sits back as the brokerage firm borrows the shares, loans them to his account and executes the sell order
  4. Waits until the security goes down in price, then buys the shares in the market
  5. Returns shares to the broker to pay back the loan
  6. Keeps the difference as profit
Both leverage and selling short carry certain risks, and both can result in a day trader losing his assets and being asked to pay back those he borrowed.

So all and all Day Trading has its advantages but it also carries higher risk factor.

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