Common Strategies for Day Traders
Playing the Spread
The spread is difference between the bid price and the ask price. Playing the spread involves buying the stock at the Bid price and selling it at the Ask price. This is seen as a safe alternative to other strategies.
In simple terms, leverage is the process of borrowing money to make more money. Leverage gives a trader the opportunity to increase the return on a trade without affecting the performance of the trade. Here is an example:
- A day trader is planning to execute a trade that will result in a 10% return. If a trader has $20,000 in his account, then his return would be $2,000. But if our trader decides to borrow another $20,000 on leverage and add it to your account, then the return on the trade will double to $4,000.
Now, the question is, where do traders get this extra money?
Most brokerage firms will give the trader the opportunity to open a margin account (usually with a minimum balance). A margin account with a brokerage firm is one where the brokerage lends the trader money to execute a trade and maximize returns. Essentially, when a trader uses a margin account, he is trading with the brokerage house’s money. This account relies on collateral, usually in the form of cash or the value of a security.
Short Selling (Shorting)
The common strategy when trading stocks is to buy low and sell high. Selling short is the opposite. When a trader opts to ‘short’ a security, he looks for one with a declining price. Like leverage, this strategy relies on borrowing. The trader will borrow a security and sell it. After the security declines in price, the trader will buy it and return it back to the lender.
Example: If security JBM is at $20 per share, a trader using this strategy will borrow 100 shares and immediately sell them for $2,000. If (hopefully) the price falls to $17, the trader would then buy 100 shares back for $1700, return the shares to their original owner and make a $300 profit (less borrowing fees).
However, this strategy also has the potential for losses. For example, if the shares of JBM increased to $25, the trader would have to buy back all the shares at $2,500, losing $500.
A trading strategy that assumes securities that have been rising steadily in price will reverse and start to fall, and vice versa.
In opposition to trend following, a trader utilizing this strategy will buy a security that has been falling, or short one that has been rising, with the expectation that the trend will change.
Playing News and Momentum
Playing the news is a strategy that relies on trading on news information, such as company financial information and performance.
Related to this, traders that trade on momentum will buy on news information and ride a trend until it shows signs of reversal (this could also work for short selling).
Although fading is a risky strategy, it can be extremely rewarding. Fading involves shorting stocks after rapid increases in price. A day trader will typically employ this strategy based on 3 criteria:
1. The price is inflated because of too many buyers in the security.
2. Owners are ready to sell for a profit.
3. Investors are pulling out of the stock. This strategy takes a keen understanding of market data (charts, trends) as well as company information.