On the surface, day trading looks like it should be easy. Jump in and out of trades as the price moves, make a little profit and repeat the process tomorrow. Unfortunately, many dangers are lurking in the markets for day traders and new day traders are unaware of these dangers and how they can drain their trading account.
In this article, we provide an overview of how day traders can avoid the common pitfalls of most traders.
Lack of Risk Management
The biggest danger new day traders face is not having risk management protocols in place, or having an incomplete risk management strategy. New traders are usually optimistic about their trading skill (why start trading if you aren’t optimistic about its potential), which can lead them to overlook important risk management steps.
Here are some steps to take to establish a basic risk management strategy.
Control your risk on each trade by placing a stop-loss order on every trade you make. When starting out as a day trader, your risk on a single trade should never exceed 1 percent of your trading account balance. The risk is defined as the difference between your entry price and stop loss price, multiplied by your position size or how many shares or lots you purchased. A Daily Limit
Controlling your risk on each trade is a good start, but if you initiate a lot of trades each day and lose on the majority of them, you may still find yourself down 10 percent or more in one day.
A daily-stop loss limit can help by limiting he how much total money you can lose in one day. Typically, the limit shouldn’t be more than about 3 percent of your account. If on any given day, you lose 3 percent, you stop trading for that day.
As you gain experience and develop a profitable track record, you can adjust your daily risk limit to be the equivalent of your average profitable day. By imposing the daily limit, any losses from a single day can be easily recouped by a typical winning day.
Lack of, or an Improperly Tested Strategy
Eager to get trading and making money, many new day traders read about a strategy, like how it looks, and so they jump in and start trying it out with real money. Others are a bit more cautious, and try demo trading the strategy first. If they make money with the strategy over a few trades, they start trading it with real money. Both of these approaches are likely to lead to disappointment in the future.
Successful day traders test out a strategy in all different types of market conditions and learn the strengths and weakness of a strategy before using it with real capital. They do this through demo trading–typically for at least three to six months (or more)–as well as looking through historical price charts and seeing how the strategy would have fared in various market conditions.
Before risking real money with a strategy, know when you should trade it and when you should stay away. Know how the strategy performs when the market is trending, ranging, whipsawing, when it is volatile and when it is calm. By testing your strategy against various market conditions, you’ll be able to implement your strategy effectively when those conditions materialize.
Your broker is the biggest trade you will make. You are depositing all your capital with them, and yet many traders don’t bother to research their broker until there is a problem.
Common broker problems include scam brokers, which are typically located outside first-world countries, although scam brokers can pop up anywhere. Scam brokers which make it very hard or impossible for you to withdraw your money and any profits once you have sent it to them. Scam brokers typically don’t last long and show up repeatably in forum complaints, so an online search should reveal any major problems with a broker.
A more subtle problem is slow quotes, or your broker is trading against you. Day traders need a direct access broker, where the broker’s software sends the trader’s order directly to the appropriate exchange. In day trading, every split-second counts, so if you place an order, you want it to get to the exchange instantly.
It’s important to test your broker’s software. A broker may offer great services, but if their software isn’t good, it will be difficult to execute trades in a timely manner.Research everything you can about a broker before sending your money to them. Trade a demo account with them for a few months, and test out their customer service. There are other factors to consider when choosing a broker, some of which are outlined in the 5 Steps for Finding a Great Forex Broker.
Let’s face it, technology problems can happen to anyone. What happens if your computer crashes? Your internet goes down? Your power goes out? What if your broker’s servers crash and you get disconnected from your broker?
There is no way for you to get out of a losing trade quickly if technology fails, which is why you need a stop-loss order in place on every trade.
Your broker’s phone number should be programmed into a landline phone and a cell phone, so you can contact them quickly if needed. If your internet goes down, it may also be helpful to have a mobile version of your broker’s trading platform on your smartphone. Your mobile internet might be operational if your computer crashes allowing you to manage your trades.