The Only Way to Day Trade

11 June 2010 - 14:12 pm

There are four cardinal principles which should be part of every trading strategy. They are: 1) Trade with the trend, 2) Cut losses short, 3) Let profits run, and 4) Manage risk. You should make sure your strategy includes each of these requirements for success.

Trade with the trend relates to the decision of how to initiate trades. It means you should always trade in the direction of recent price movement.

Mathematical analysis of commodity price data has shown that these price changes are primarily random with a small trend component. This scientific fact is extremely important to those desiring to pursue commodity trading in a rational, scientific manner. It means that any attempt to trade short-term patterns and methods not based on trend are doomed to failure. It also explains why day trading is darned difficult and why almost no day trader is a long-term success.

The shorter the time frame in which you examine price action, the smaller the trend component is. Commodity price action is fractal. That means that as you shorten or lengthen the time frame, price action remains similar in behavior. Thus, five-minute charts have roughly the same appearance as hourly charts, daily charts, weekly charts and monthly charts.

This similarity in chart appearance convinces traders that you can day trade successfully with the same tools you use on longer-term charts. Of course, they try to use much of the arsenal of technical analysis that doesn’t work on long-term charts either. Things like Oscillators, Candlesticks and Fibonacci numbers.

However, even trend-following tools that work in intermediate to long-term time frames won’t work in day trading. This is because the trend component is so very small in short-term data that you must use a highly effective method to overcome the costs of trading.

In longer-term trading, you can let your profits run. You do it by definition or it wouldn’t be long-term trading. In day trading you can only let your profits run to the end of the day. This means your average trade (the average profit of both your winning and losing trades) must necessarily be much smaller than if you could let your profits run for days, weeks or months. However, your costs of trading–slippage, commissions, the bid/asked spread and mistakes–stay roughly the same on a per trade basis. Thus, your day trading system must be much more consistent and robust to stay ahead of the costs of trading than would an intermediate to long-term system. There are few day trading approaches that meet this test.

Since market price action is mostly random, successful trading methods must somehow exploit a non-random feature of market price action. The tendency of most markets to trend is the only possible edge in trading, so a winning approach must harness trend in some way. Tradeable trends do not show up often in the very short term. They certainly are not present every day. That is why the person who tries to day trade at least once every day, and perhaps even more often, is doomed to failure. The more often you day trade, the more likely it is that you will be a long-term loser.

There is a wonderful fantasy about day trading. You get up in the morning, have a nice breakfast and go to your home office. There you have a powerful computer with fancy software that brings you real-time intraday charts and quotes. You look over the day’s market activity and find some promising situations. You watch the markets for awhile until a suitable trade presents itself. You pick up the phone and call your broker to make your trade entry. Then it’s time to relax and grab a hearty cup of coffee or a frosty glass of juice while you watch your profits mount. By the end of the day, you are out of your position with a nice profit. Most days are profitable, although not all. You seldom have a losing week. Never a losing month. You make as much money as you need. Some days you don’t bother with trading at all. You have better things to do. You play golf, sail, do lunch. You take extended vacations whenever you want. Life is sweet.

There are plenty of people out there ready to sell you a day trading course or system for thousands of dollars that will show you how to implement this fantasy. The only problem is they haven’t been successful traders. They make money only by selling their losing methods to others.

Here’s what trading legend Larry Williams said about day trading: “If you’re day trading, you’re going to end up frying your brain. When you go home, you’re not going to be a nice person to be around. I’m already not too a nice a guy to be around. So when I do a lot of that type of trading, who would want to be around me?

“All the day traders I talk with are losing money. The oscillators, the supposed support and resistance levels, all that other technical analysis stuff out there doesn’t work very well in day trading. Plus I found I make more money by holding overnight and trading out of positions in the next day or two. If I’ve really got a strong signal, it should last for more than a few hours.”

Gary Smith is the only person with a documented long-term success record in day trading. He made money consistently for over ten years. However, he trades relatively infrequently, maybe once or twice a week. “Successful day trading is not an everyday affair and not a multiple trade affair,” he cautions. “Inexperienced day traders simply refuse to accept this.” Gary’s book, published by Reality Based Trading, is called Live the Dream by Profitably Day Trading Stock Futures.

I have been day trading successfully for the past couple of years using a system that trades on average only two or three times a month. I have also recently published a second day trading system that trades only once or twice a month. Of course, I make almost all my money trading with my more effective long-term systems. For me, day trading is only for fun and for a little diversification. These systems are available from our company.

If you want to be a successful trader, your best chance is with a long-term, trend-following system. If you must day trade, don’t do it very often. The more you trade, the more likely it is you will lose.