If you are going to day trade, it’s essential to have a set of rules to manage any possible scenario. Even more important, you must also have the discipline to follow these rules.
Sometimes, in the heat of battle, traders will throw out their own rules and play it by ear — usually with disastrous results.
Although there are many rules, the following are the 10 most important:
1. The three E’s: enter, exit, escape
Rule No. 1 is having an enter price, an exit price, and an escape price in case of a worst-case scenario. This is rule number one for a reason. Before you press the “Enter” key, you must know when to get in, when to get out, and what to do if the trade doesn’t work out as expected.
Escaping a trade, also known as using a stop price, is essential if you want to minimize losses. Knowing when to get in or out will help you to lock in profits, as well as save you from potential disasters.
2. Avoid trading during the first 15 minutes of the market open
Those first 15 minutes of market action are often panic trades or market orders placed the night before. Novice day traders should avoid this time period while also looking for reversals. If you’re looking to make quick profits, it’s best to wait a while until you’re able to spot rewarding opportunities. Even many pros avoid the market open.
3. Use limit orders, not market orders
A market order simply tells your broker to buy or sell at the best available price. Unfortunately, best doesn’t necessarily mean profitable. The drawback to market orders was revealed during the May 2010 “flash crash.” When market orders were triggered on that day, many sell orders were filled at 10-, 15-, or 20 points lower than anticipated. A limit order, however, lets you control the maximum price you’ll pay or the minimum price you’ll sell. You set the parameters, which is why limit orders are recommended.
4. Rookie traders should avoid using margin
When you use margin, you are borrowing money from your brokerage to finance all or part of a trade. Full-time day traders (i.e. pattern day traders) are usually allowed 4:1 intraday margin. For example, with a $30,000 trading account, you’ll be given enough buying power to purchase $120,000 worth of securities. Overnight, however, the margin requirement is still 2:1.
When used properly, margin can leverage, or increase, potential returns. The problem is that if a trade goes against you, margin will increase losses. One of the reasons that day trading got a bad name a decade ago was because of margin, when people cashed in their 401k(s) and borrowed bundles of money to finance their trades. When the bull market ended in 2000, so did many traders’ accounts. Bottom line: if you are a novice trader, first learn how to day trade stocks without using margin.
5. Have a selling plan
Many rookies spend most of their time thinking about stocks they want to buy without considering when to sell. Before you enter the market, you need to know in advance when to exit, hopefully with a profit. “Playing it by ear” is not a selling strategy, nor is hope. As a day trader, you’ll set a price target as well as a time target.
6. Keep a journal of all your trades
Many pros swear by their journal, where they keep records of all their winning and losing trades. Writing down what you did right, or wrong, will help you improve as a trader, which is your primary goal. Not surprisingly, you’ll probably learn more from your losers than your winners.
7. Practice day trading in a paper-trading account
Although not everyone agrees that practice trading is important, it can be beneficial to some traders. If you do open a practice account, be sure to trade with a realistic amount of money. It’s not helpful to practice trade with a million dollars if the most you have in your account is $30,000. Also, if you do practice trade, think of it as an educational exercise, not a game.
8. Never act on tips from uninformed sources
Most pros know that buying stocks based on tips from uninformed acquaintances will almost always lead to bad trades. Knowing what stocks to buy is not enough. You also have to know when to sell, and by then the tipster is long gone. Legendary trader Jesse Livermore said it best when he wrote this about tips: “I know from experience that nobody can give me a tip or a series of tips that will make more money for me than my own judgment.”
If you can’t trust your own judgment, you may want to avoid day trading altogether.
9. Cut your losses
Managing losing trades is the key to surviving as a day trader. Although you also want to let your winners run, you can’t afford to let them run for too long. It’s more art than science to get it right, but learning how to control losses is essential if you are going to day trade. Once again, never forget the three E’s: (enter, exit, and escape).
10. Be willing to lose before you can win
Although many traders can handle winners, controlling losing stocks can be difficult. Many rookies panic at the first hint of losses, and end up making a series of impulsive trades that cost them money. If you’re day trading, you must be willing to accept some losses. The key: know in advance what you’ll do if you’re confronted with losses.
Although anyone can learn to day trade, few have the discipline to make consistent profits. What trips up many people are their emotions, which is why it’s so important to create a set of flexible rules. Your goal: follow the rules to help keep you on the right side of any trade.