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Understanding the Risks of Day Trading

By MP Dunleavey · January 04, 2022 · 8 minute read

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Understanding the Risks of Day Trading

Day trading is when an investor buys and sells stocks or other assets hoping to profit from short-term price movements. Day traders don’t usually seek investments that could make money over the long term; they’re focused on short-term gains.

How risky is day trading? Generally, there are far more day trading risks than with traditional buy-and-hold strategies. Day trading requires a higher level of sophistication; it has different cost implications, potentially substantial tax outcomes, and involves a greater degree of risk exposure — especially if you trade on margin (which involves borrowing funds to place bigger bets).

Day trading appeals to some investors because they believe it may also offer the potential for quick profits and higher returns. In order to decide if day trading is right for you, it’s best to understand how day trading works and the potential risks involved.

What Is a Day Trader?

You don’t need a special license to become a day trader. Rather, day trading is defined by the frequency of trades (or if the investing firm determines that a customer qualifies as a day trader). According to the technical industry definition, the Financial Industry Regulatory Authority (FINRA) and New York Stock Exchange (NYSE) classifies day traders as such when they trade four or more times during a five-day span, assuming the number of day trades is more than 6% of the investor’s total trading activity in that time.

But day trading inherently involves an elevated level of risk. So when you ask, “How risky is day trading?”, here are a few other points that distinguish day traders from ordinary investors:

Tracking Market Trends

For some, investing implies a desire to purchase an item that will increase in value over time. This is often done through a fundamental analysis of an investment, including its price relative to value. That in-depth analysis is typically not of interest to a day trader.

Rather day traders often use what is called technical analysis — the study of what has happened to the price of stock in the past. Using these types of analyses, day traders attempt to detect patterns in a security’s performance, called trends. Although this method is common among day traders, many in the financial industry debate the validity of these patterns and whether they can be predictive, or help investors anticipate a security’s future performance in any way.

Quick Trades

In addition to tracking trends, day traders are also highly attune to news and events that can swiftly impact market conditions, and are ready to act on these.

That’s why day traders typically must be highly experienced investors who are comfortable with split-second decisions, and can monitor economic factors, as well as markets and news cycles to gauge the performance of different companies and industries in order to make quick trades. The idea isn’t to wait for a bigger gain, but to capitalize on market inefficiencies and minute price changes by executing a large volume of short and long trades.

A Range of Securities

Day traders can trade a wide range of asset classes and securities: company stocks, fractional shares, ETFs, bonds, fiat currencies, cryptocurrencies, or commodities like oil and precious metals. They can also trade options or futures — which are types of derivatives contracts. But they’re typically most active on the foreign exchange or forex and stock markets.

Perhaps the most distinguishing characteristic of day traders is their comfort with risk. Let’s look at some common day trading risks.

What Is a Pattern Day Trader?

A pattern day trader (PDT) is a regulatory designation that’s similar to the basic day trader classification. You’re considered a PDT when you execute four or more day trades over five business days using a margin account — and when those trades make up more than 6% of all trade activity from that account.

When that threshold is met, the broker holding the margin account will typically flag the trader as a PDT. This places restrictions on the investor’s ability to trade. For example, when investors are identified as pattern day traders, they must have at least $25,000 in their trading account. Otherwise, the account could be restricted per FINRA’s day-trading margin requirement rules.

The PDT designation is set up to prevent investors from trading excessively.

Lack of Risk Management

Because day trading is entirely self directed, a day trader must be willing to manage the risks they take on. There’s no advisor or broker to run interference.

One of the biggest day trading risks involves the use of leverage, or borrowing money in order to place trades. To make leveraged trades investors need to open what’s called a margin account with their brokerage firm. A margin account allows investors to consider taking much larger positions because they can use cash plus borrowed funds to make a trade.

For example, if an investor wanted to buy $10,000 worth of Stock X, using a margin account they could pay $5,000 in cash and borrow $5,000 on margin.

Let’s say the stock moves in the right direction, going up to $1,200. The investor could pocket the $200 gain and repay the $5,000 margin loan.

If the stock loses value, though, the investor could then be on the hook for a much bigger loss. They could lose some of their own capital and have to repay the margin loan with interest.

Also, leverage isn’t just used for straightforward buying and selling of a single stock. Typically investors use leverage to trade more complex investments like options and futures contracts. Although options and futures are different trading strategies, they’re similar in that an investor buys a contract for an underlying security or commodity, and then may trade these contracts with the aim of hedging another security or profiting from turns in the market.

How Risky Is Day Trading? 3 Key Factors

Buy-and-hold investors often analyze company fundamentals in order to gauge a longer trajectory. They may weigh factors such as revenue, price-to-earning ratio, assets vs. liabilities, and so on, in order to minimize risk. Because day traders are price focused, they’re not examining the overall quality of a given security or its long-term growth potential, but rather how they might exploit short-term gains. Here are three key factors for day traders:

1. Liquidity

Liquidity refers to how quickly an asset can be bought and sold without causing a significant change in its price. In other words, how smoothly can a trader make a trade?

Liquidity is important to day traders because they need to move in and out of positions quickly without having prices move against them. That means prices don’t move higher when day traders are buying, or move down when they’re starting to sell.

2. Volatility

Market volatility can often be considered a negative thing in investing. However, for day traders, volatility can be essential because they need big price swings to potentially capture profits.

Of course, volatility could mean big losses for day traders too, but a slow-moving market typically doesn’t offer much opportunity for day traders.

3. Volume

High volume may indicate that there is a lot of interest in a security, while low volume can indicate the opposite.

Elevated interest means there’s a greater likelihood of more liquidity and volatility — as discussed, two other characteristics that day traders look for.

5 Common Day Trader Strategies

There are several techniques that day traders use to take advantage of market inefficiencies and price fluctuations. Here are a few common ones:

1. Scalping

This strategy refers to a basic day trader strategy: aiming to seize a number of small gains throughout the day by capitalizing on often tiny price movements. Scalping may also include short-lived arbitrage opportunities.

2. Fading the Gap

Fading the gap at open is a way that day traders try to find an opportunity when there is a gap between the market’s opening price and the previous day’s close. When there is such a gap, day traders may take a position in the opposite direction of the gap, and hope to profit from the change.

3. News-Based Trading

As it sounds, this strategy typically seeks trading opportunities in the heightened volatility around news events and headlines.

4. Range Trading

A trading range, also called a price channel, is when a security trades consistently between a band of high and low price limits. Day traders seek to exploit the range by making buy and sell decisions based on the support and resistance levels of the lowest and highest prices in the range.

5. High-Frequency Trading (HFT)

These strategies use sophisticated algorithms to exploit small or short-term market inefficiencies up to several thousand times in a single day.

Top Risks of Day Trading

Here are some of the biggest risks of day trading.

Financial Losses

Depending on the day trading strategy, it is 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 funds borrowed from a margin account, which must be repaid with interest.

That said, there may be strategies that make sense for different investors, whereby investment losses can be used to offset the taxes owed on gains.

Trading on Margin — and Losing

As noted above, it’s a common practice for day traders to use borrowed money to engage in popular strategies such as short selling and forex trading. Buying on margin or trading on margin enables day traders to place bigger bets by using money borrowed from their brokerage account. By using leverage in this way, investors have the opportunity to multiply their profits, but the losses can also be steep — and the money must be repaid with interest.

Taxes

One hazard of day trading is the potential tax implications. In most cases, short-term gains, from securities that you hold for a year or less, are taxed at your normal income tax rate (listed here for the 2021-2022 tax year). Long-term gains, from securities held for more than a year, are typically taxed at a lower rate. Given that most day traders may have more short-term gains vs. long-term, the higher tax impact is something to consider.

Time Commitment

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

The risks of these different outcomes are something for would-be traders to consider.

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 typically pay numerous fees and commissions. Also, training, software, computers, and research can easily run up a trader’s costs — all of which should be factored into any hoped-for returns.

Scams, False Claims, and “Expert Advice”

Day traders are typically in the market to make a quick profit. Combine this with the difficulty of forecasting the direction of the stock market and it creates a rich environment for scams, false claims, and pricey advice from people who may bill themselves as “experts.”

When working with a trading firm, the SEC recommends that investors inquire about the portion of their clients who have lost money. Furthermore, when receiving any financial advice — whether from individuals, firms, educational seminars, classes, or books — it is important to research 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 day trading strategies, it’s wise to consider the risks as well as the overall cost. Day traders are typically highly experienced investors, attune to market conditions as well as events that can impact the pricing of different securities. They’re accustomed to moving quickly to exploit small price movements in order to profit. In this way, day trading is basically the opposite of traditional buy-and-hold investing, as there is no focus on underlying fundamentals or long-term outcomes.

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. Many day traders use margin accounts that enable them to borrow additional funds to place bigger bets. While trading on margin can allow traders to see bigger gains, it also exposes them to the risk of bigger losses if their positions don’t pan out.

To learn more about the basics of trading and explore the strategies that will work for you, it’s easy to get started by opening an online brokerage account with SoFi Invest®. Investors can buy and sell stocks and ETFs, as well as cryptocurrencies. SoFi doesn’t charge commission, which allows investors the opportunity to test their trading strategies and skills without excessive costs.

Learn more about the investing strategies that suit you with SoFi Invest®.


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