Frequently Asked Questions: Day Trading, Prop Trading and Trading Strategies

In the late 1990s, for the first time ever investors were presented with the concept of “online trading” where they can buy and sell any stock through their computer using an online brokerage account. Prior to this new phenomenon investors would have to place a phone call to their stock broker and would stay on the line for minutes to get confirmation of a trade. As a result of this new convenience and lower cost of investing a new trend known as day trading grew in popularity. Day trading is simply the process of buying and selling securities throughout the day for short term gains. What is day trading? As previously mentioned a day trader will trade certain securities with the hopes of making short term gains throughout a regular trading session. A typical day trader will start each day with no open positions and will finish the day having sold all positions before the market closes. This is a precaution in the event that a news announcement will be released that can impact the market in one way or another. Due to globalization all major markets are more and more connected. When it is 3AM in New York it is regular business hours in Europe so a negative news release at that time can impact the opening prices of stocks the following open. Not having an open position reduces completely this major risk. How many shares does a day trader trade? Since the definition of day trade is very vague there is no “minimum” number of shares. One day trader can trade 1000 shares while another can trade 10 million. At the end of the day the only data that really matters is profit earned, not shares traded. Can anyone day trade through their brokerage accounts? Short answer is no. Brokerage accounts owned by a United States company has very strict limitations on who can day trade. All accounts with less than US$25,000 can not place more than 4 round trip trades within a 5 day successive period. This law is known as “pattern trading” and comes directly from the Securities and Exchange Comission (SEC.) The holder of an account can not buy and sell the same stock more than 4 times within a 5 day period. Other countries may have similar restrictions. What is a proprietary firm “prop firm”? A prop firm is a private company that provides its members access to firm capital, trading tools and advanced trading software to generate a profit. A prop firm is a private corporation and does not accept retail accounts or customers. What are the advantages of trading through a prop firm? The greatest advantage is that traders are not limited by SEC regulation regarding pattern trading. Moreover, prop firms offer sophisticated tools and software that are not available in regular retail accounts. Some of these features include:

• Built in scanning tools that will scan every stock according to specific criteria such as hitting a new daily high or unusual volume.
• Ability to trade on dozens of destinations which can result in substantially faster and cheaper executions versus retail accounts.
• Ability to send orders directly to market makers.
• Ability to send orders directly to the floor of the exchange (such as NYSE floor)
• Ability to send orders to destinations that will fill at a “midpoint.” For example if a trader is trying to buy a stock at $4.75 but is finding it difficult to enter, a midpoint order will attempt to buy the stock at $4.755. The trader will pay half a cent more per share but will likely get filled quicker.
• Ability to send orders to dark pools. An order sent to a dark pool is hidden from the market and a pending order will not appear anywhere within a level 2 quote. Suppose Rebecca wants to sell a very large number of shares but is afraid to do so in the open market because other participants will see a very large order, and might panic and start selling their shares as well. This will negatively impact Rebecca because the stock has dropped so she now has to settle for a lower price per share. If an order is sent to a dark pool it will remain hidden and un-viewable to the public and will get filled “secretly.”
• Ability to participate in opening and closing auctions. These auctions are unique single-price Ductch auctions that matches buy and sell orders at the price that maximizes the amount of tradable stock. For example, the closing auction, also known as “market on close” is conducted at exactly 4:00PM. In simple terms: suppose an ETF manager needs to rebalance their holdings and has to buy 30 million shares of Bank of America BAC This type of order is handled by a floor specialist on the NYSE. The specialist will advertise this large order to all qualified market participants beginning at 3:45pm. Armed with this information a day trader will know that the price of BAC will close at a higher price because of the large demand on the buy side (referred to as a buy side imbalance.) A skilled trader will quickly buy shares of BAC and place an order to add his shares to the auction and will do so by placing an order directly to the floor specialist. The trader then waits for the closing bell at 4:00pm for the order to be executed.

What are some of the different day trading strategies? Scalping is a very popular strategy where the objective is to achieve an extremely small profit ranging anywhere from 0.5-3 cents per share. A scalper will place limit orders to buy at the bid and will immediately post a selling order to sell on the ask. Sirius XM Radio SIRI is a very popular stock to scalp due to the extremely low volatility (the stock rarely moves more than 5 cents a day in either direction during normal market conditions) and has extremely high liquidity. As a result, SIRI is amongst the most actively traded stocks on all major exchanges daily. As we can see in the level 2 quote, SIRI is extremely liquid meaning there are tens of thousands of shares available on both the bid and ask side so scalpers can enter positions with relative ease.
Contrarian trading is a high risk strategy and is utilized by a trader when they believe that a stock that has been rising steadily will reverse and start to fall, and vice versa. A contrarian trader will recognize an opportunity when they believe that a stock is being “overbought” or “oversold.” For example a contrarian trader will have noticed the chart below and observe that Apple AAPL is risen substantially and the trader does not believe this will continue much longer. The trader will place short sell orders in hoping that the stock will turn around and start dropping so the short position can be covered at a lower price resulting in a profit. As we can see in the chart below, AAPL has risen over $2 from $419.75 to over $422 a share. A contrarian investor would have profited from this scenario by placing a short sell order at some point close to AAPL's peak. AAPL hit a high of $422.69 and has dropped over $2 per share since peaking.
Momentum trading occurs when a trader simply “goes with the flow” and will buy a stock that is rising and hold on to it until momentum dies off. The trader will then sell the position and can enter a short position of the same stock if selling momentum builds up. In the example below, the Volatility Index ETF VXX provides an example of momentum trading. By studying the chart we can see momentum builds up and there is either strong buying or selling. A momentum trader would attempt to profit from this situation by buying when buying momentum is building up and will then sell the position while simultaneous entering a short position in hoping the downward trend continues.
Range trading occurs when a trader uses indications such as a resistance or support price to enter a position. A support price is a “minimum” price that market participants are comfortable with the stock and market participants find the price attractive and a good buy. A support price is a price at which the market participants deem the stock to be too expensive and once the price is reached it will be sold off. A clear example of this can be found in the Research In Motion RIMM chart. As we can see, RIMM has a support price at around $15.27 which a range trader will take this as a buy signal. $15.44 is the resistance price and indicates an opportunity to sell a position or to short sell the stock.
Full disclosure: Jayson is director of trading at TM Global Capital an offshore proprietary equity trading firm and has been a contributing author to benzinga.com since November 2010.