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Understanding the Risks of Day Trading

November 24, 2020 · 5 minute read

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Understanding the Risks of Day Trading

To some, day trading may sound exciting. During the day, when the stock market exchanges are open, day traders attempt to capitalize on the short-term changes of the prices of stocks and other volatile investments. They may place many trades throughout the day in an effort to quickly secure profit. They may even use borrowed money to place trades, which both increases risk and the potential for reward.

But others may wonder, Is day trading bad? According to the US Securities and Exchange Commission
(SEC)
, the regulatory body created to protect investors after the Great Depression, day trading is “neither illegal nor is it unethical.” But it is highly risky. The SEC’s take: “Most individual investors do not have the wealth, time, or the temperament to make money and to sustain the devastating losses that day trading can bring.”

Here’s a peek into the high-stakes world of day trading, as well as some day trading risks.

Who is a Day Trader?

In the world of investing, there are long-term investors, day traders, and everything in between. While a long-term investor may employ a strategy that involves purchasing investments to hold for years or even decades, a day trader may keep a stock for only minutes or hours, and close out all positions prior to the end of the trading day, due to the possibility of wide price swings overnight. Day traders may also look to exploit changing prices using ETFs, futures, options, and currencies.

Investing implies the desire to purchase an item that will increase in value over time—to pick a “good” investment. This is often done through a fundamental analysis of that investment, including it’s price relative to value. That in-depth analysis is not of interest to a day trader.

Both “bad” and “good” investments may experience price fluctuation, despite (or in lockstep with) its overall trajectory. And that’s where a trader hopes to capitalize—on price short-term volatility, whether or not the investment is “fit” for long-term holding.

Day traders often use what is called technical analysis—the study of what has happened to the price of stock in the past. Day traders attempt to detect patterns of motion, called trends. (It should be noted that across the industry, there is plenty of disagreement as to whether such patterns exist, or whether there is any real way to read trends in a consistently repeatable way.)

In the short-term, factors such as changes in investor sentiment may drive stock prices. In other words, the very forces of buying and selling—also known as supply and demand—cause prices to wiggle. Goings-on at the company and the world at large absolutely matter, but nothing has a unilateral impact on prices. For example, a solid earnings report may influence investors to buy—but it also might not. Also, what incentivizes one investor to buy or sell a stock may not factor into another investor’s decision. All of the many factors that influence demand, added together, create volatility.

Top Risks of Day-Trading

Because there is no single method for consistently predicting global investor demand, day trading is particularly tricky. Further, the market may process out any widely-known strategy. (For any popular strategy, there will surely be plenty of market participants willing to take the opposing stance.) Day trading relies on imperfect science, resulting in plenty of opinions on whether or not day trading is bad.

Day trading is certainly not for the risk averse. Here are some of the biggest risks of day trading.

Financial losses

Depending on the day trading strategy, it is certainly possible to lose hundreds or thousands of dollars—or more—in the course of just one trading day. Further, it is possible to both lose the entire amount invested (the principal) including any borrowed money, which must be repaid.

Trading on margin—and losing

It is a common practice for day traders to use borrowed money to engage in popular strategies such as short selling and forex trading. Trading or investing on a loan from the broker is called “buying on margin” or “trading on margin.” By using borrowed money, investors have the opportunity to multiply their profits using leverage. But just as quickly as leverage can generate profit, it can destroy wealth.

Stress

Imagine a scenario where an investor has been watching trend graphs on a computer screen for hours on end, only to have a small fortune wiped away by one wrong bet. Between the constant possibility of losing money and the time spent monitoring the market, day trading is a demanding endeavor.

Time commitment

Day trading requires hours at a time at a computer, tracking the prices of different stocks. It also requires research into different methods, training and practice, and ongoing learning—none of which comes with a guaranteed pay-off. For some day traders, what starts as a hobby can morph into a full-time job, an obsession, or even a case of pathological trading.

Expense

Day trading can be expensive. Though the total cost will depend on factors like the types of transactions and the brokerage bank or trading platform used, traders should prepare for fees and commissions. Additionally, training, software, computers, and research can easily run up a trader’s bill—all of which could impact any return on their investment strategy.

Scams, False Claims, and “Expert Advice”

Day traders are typically in the market to make a quick buck. Combine this with the sheer difficulty of forecasting the direction of the stock market in any predictable way and it creates a rich environment for which scams, false claims, and pricey advice from non-experts.

When working with a trading firm, the SEC recommends that investors inquire as to the proportion of their clients that have lost money. Furthermore, when receiving any financial advice—whether from individuals, firms, educational seminars, classes, or books—it is important to know both the experience and credentials of the person giving the advice, as well as their incentive structure.

All trading firms must register with both the SEC and the states in which they operate. One thing day traders can do to ensure their safety is call their state securities regulator and inquire about both the firm’s registration and track record with regulators, and customer complaints. To obtain the number of a state regulator, visit the North American Securities Administrators Association’s website .

The Takeaway

Day trading is a high-risk, high-pressure pursuit. For those interested in utilizing day trading strategies, it’s smart to consider the cost. Many major brokerage firms can accommodate day trading, however, it can be costly to place each trade. It’s important to account for the cost of these fees, called transaction or trading fees, when calculating any potential profits.

With SoFi Active Investing, investors can buy and sell stocks and ETFs with no commissions. This allows investors the opportunity to test their trading strategies and skills without prohibitive costs.

For investors that prefer a fully-built portfolio and passive strategy, SoFi Automated Investing builds an investment strategy tailored to the individual—and does all the work to keep it running smoothly.

Find out more about no-fee trades and no account minimums with SoFi Invest®.


SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

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