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Poor risk management kills most day traders (and short-term traders)!

Good risk management is essential in the trading game.

If your risk capital is, say, $10,000 then you should risk no more than 5% (= $500) on any one trade. That means that you could afford almost 20 consecutive losing trades before your capital is lost.

The worst run you are likely to have is maybe five or six consecutive losing trades, so you will stay in the game longer term if you have good risk management.

Poor risk management is the reason why most day traders and short-term traders lose their investment capital, usually within a very short time frame.


The other reasons why day traders usually lose

There are two other reasons why most day traders are unsuccessful.

Firstly, day traders under-estimate the effect of the share price spread.

Let’s say the dealing cost is something negligible like $10 per trade. Then your main cost is the share price spread. So, let’s say the shares you intend to trade are at $52.50 to $52.60. The share price ‘spread’ here is 10 cents, so the price must move up (or down if you are ‘shorting’ the shares) by this amount before you move into profit.

10 cents of a movement might not seem like much, but the average daily volatility of that stock might only be, say, half of one per cent (0.5%). That equates to approximately 25 cents on the share price. The share price spread of 10 cents therefore amounts to 40% of the average daily volatility.

Your dealing cost therefore for day trading is not a mere $10 to buy and $10 to sell….. Your dealing cost is actually something like 40%!

The second reason why most day traders lose is because they are trading against market-makers who have more information than the day traders, during any trading session.

Take again our example of a stock trading at $52.50 to $52.60.

The day trader might be paying $20 or $30 per month for ‘level 2’ prices on an internet site, thinking that this will give him real time prices and trades, and all the information the market-makers have.

However, the market-makers are allowed to not report large trades during the session, so that their positions in the market are protected. These large trades are reported after the market closes that day.

So, let’s say the shares are trading at $52.50 (bid) and $52.60 (offered) and a large shareholder wants to sell 1 million shares.

What will happen here, is that the stockbroker acting for the large shareholder will contact a market-maker and agree a sale of the 1 million shares at, say, $51.90. (The $52.50 bid price is only for a limited number of shares, usually about 1,000).

This large sale of 1 million shares at $51.90 will not be reported until after the market closes that day. The price will stay around $52.50 to $52.60 and the market-maker will gradually sell those shares throughout the day.

That market-maker will know that the shares are not going to rise for the duration of the session, because he has so many to sell – his sales throughout the day will keep the price down.

The day trader, on the other hand, does not know that the market-maker has a huge position to offload, and might decide to buy the shares. No prizes for guessing who is going to make money and who is going to lose money here…


The one day trade that usually works

In my experience, there is only one day trading strategy that works, and it is as follows:-

XYZ Corp announces bad news after the closing bell today, such as a profits warning or negative development in the industry sector etc.

When the market opens tomorrow, there will be a glut of sale orders and hardly any buy orders. The market-makers are obliged to step into the market in situations like this, and buy the stock when there is this type of order imbalance.


So, tomorrow at the open of the market, what will happen is that the stock will ‘gap’ down sharply in price. If the stock closes at $52.50 to $52.60 today, then it will open at something like $39.25 to $40.10 at the open of trading tomorrow.


The market-makers will set the opening price, and given that they have been forced to buy all this stock from frantic sellers, they are not going to be very generous in the price they bid!

Usually what happens here is that having opened at $39.25 to $40.10 (note that the spread widens when the market is volatile, just to give the market-makers even more protection), the price then rallies during the day and closes at something like $45.20 to $45.50.

Therefore, the trade for the day trader here is to put in an order before the market opens to buy some shares. Do not set a limit and do not wait for the market to open before you put in your order.

You will then be on the same side of the market as the market-makers, and that is the only way to win at this game!


Do not hang around for too long after you get confirmation that your purchase order has been done. Sell into the rising market, as there can sometimes be a second wave of selling later in the session.



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