How to Become a Day Trader

Now that Internet stocks have died their pitiful and well-deserved deaths, it is only natural to expect day trading would not survive. After all, day traders piled on when stocks like Yahoo! and Amazon.com were going to the moon, so one would expect them to be casualties when technology stocks collapsed in the spring of 2000. But day trading remains-with fewer but wiser participants. Like fleas, day traders leapt from the dying carcasses of the dot-coms to ride on the backs of other stocks.

A little history is required to understand how what is essentially an adult video game became a legitimate business. Day trading, or the intraday trading of stocks for short-term profit, first became practical in January 1997, when NASDAQ allowed individuals to display their best bids and offers. This type of information, called Level III, is the core requirement for direct-access trading (DAT). At the same time, commission rates, which had previously eaten up all the profit on small trades, dropped to where it became possible for little guys to trade with the big guys on more or less even footing.

A raging bull market, particularly in technology stocks, caused droves of people to get day trading fever. Meanwhile, a constant stream of articles in the popular press proclaimed how students, housewives, and laid-off executives made a fortune from day trading. There are an estimated 5,000 to 7,500 hardcore day traders and as many as 50,000 occasional day traders in the U.S. Many trade from their homes. Others trade from trading rooms set up for the purpose at brokerage firms. Some even sneak a few trades at work. Day trading is premised on the fact that investors frequently overreact to the news of the day. Overreactions create opportunities for traders, who can get in after good news has been overbought or bad news has been oversold. The main thrust of day trading is simple: create short-term profits by guessing correctly which way a stock will move, and aggressively act to truncate losses when you guess wrong.

Think of it this way. In a perfectly neutral market, stocks have an even chance of going either up or down. If a stock moves the wrong way, the day trader reverses the trade immediately and takes a small loss. If it moves the right way, the day trader lets it run but takes a profit at the first sign of weakness. Over time, good (or lucky) traders' wins more than offset their loses. Entry and exit from a position can occur within minutes. The average day trader makes 29 trades, or almost 15 roundtrips per day. Speed is in. Fundamentals and prosaic information like the company's market position are out the window.

A report issued in 2000 by the Senate Permanent Subcommittee on Investigations said 77 percent of all day traders lose money. Nevertheless, there is no question that some of the other 23 percent make pots full. If you are unemotional, disciplined, have a high tolerance for risk, and possess $50,000 to $100,000 in capital, you too can be a day trader.

The first thing a new trader should do is take a training course (offered by brokers and others) to get a general feel for trading and the markets. After that comes the most important part-spending time on a simulator. You can purchase or rent the simulation software from your broker or various other vendors. Be sure the simulator you choose uses live quotes so you can test your trading acumen in real time. Spend as much time as you need on the simulator. It is a very inexpensive way to make mistakes.

The next step is to open a brokerage account with a direct-access trading firm, of which there are dozens. These firms offer volume commission discounts, rapid executions and confirmations, real-time account information, and sophisticated trading software. In addition, good direct- access brokers offer trading facilities, ongoing support, and training programs. (Note: There is a significant difference between DAT firms and regular online brokers, like Charles Schwab and E*TRADE, that do not allow regular customers to post orders directly to the markets. Day trading is not for everybody. There is immense financial risk to people who are undisciplined. Still, how else can you make several hundred thousand dollars a year sitting in front of a computer in your underwear? And despite the negative press, not everybody loses. In a 1999 study by the DAT broker Momentum Securities Management, 58 percent of rookie day traders lost money during their first three months trading, but 65 percent made money after five months.