Day Trading Strategy — What Is It? (Backtest)

Last Updated on August 28, 2022 by Oddmund Groette

In the past, the only people who could trade actively in the stock market were those working for large financial institutions, brokerages, and trading houses. That is no longer the case today, as many individual traders make a living day trading stocks or futures. But what exactly is day trading?

Day trading is a trading approach in which a trader buys and sells a financial instrument within the same trading day, with the aim of exploiting the inevitable up-and-down price movements that occur during the trading session. The trader ensures that all positions are closed before the market closes for the trading day to avoid unmanageable risks and negative price gaps between one day’s close and the next day’s price at the open.

In this post, we focus on day trading and how to profit from it.

What is day trading?

Day trading is a trading approach in which a trader buys and sells a financial instrument within the same trading day. That is, the trader ensures that all positions are closed before the market closes for the trading day to avoid unmanageable risks and negative price gaps between one day’s close and the next day’s price at the open. Day trading aims to exploit the inevitable up-and-down price movements that occur during a trading session.

Traders who trade in this capacity are generally classified as speculators, in contrast with the long-term investors who often buy and hold their investments for a long time. Day trading is similar to swing trading, in which positions are held for a few days, and it is made easier using day trading software.

While it is most common in Forex and futures trading, it is also very popular in the stock markets. Day traders are typically well-educated in the minutia of trading and are attuned to events that cause short-term market moves. Many of them use leverage to increase the size of their stakes. In other markets, like Forex and futures, day traders can trade with as low as $1,000 or less, but stock day traders tend to be well funded, in accordance with the pattern day trader rules.

The pattern day trader rules

The Financial Industry Regulatory Authority (FINRA), the self-regulatory organization that regulates member brokerage firms and exchange markets in the US, designates a pattern day trader as one who executes four or more “day trades” within five business days — provided that the number of day trades represents more than six percent of your total trades in the margin account for that same five business day period.

A pattern day trader is required to maintain minimum equity of $25,000 in their margin account on any day that the customer day trades. This minimum equity, which can be a combination of cash and eligible securities, must be in the trading account before engaging in any day-trading activities — if the account falls below the $25,000 requirement, the pattern day trader will not be permitted to day trade until the account is restored to the $25,000 minimum equity level.

Also, a pattern day trader cannot exceed their day-trading buying power, which is generally up to four times the maintenance margin excess as of the close of trading the day before. This maintenance margin excess is the amount by which the equity in the margin account exceeds the required margin. In other words, pattern day traders are only allowed up to 4x leverage.

How to by-pass the pattern day trader requirement

It is still possible to day trade the US stock market without meeting FINRA’s pattern day trader rules. One way to do that is to trade stock options via some day trading platforms like Robinhood. With stock options, you don’t need to maintain a $25,000 margin on your trading account.

Another way to day-trade US stocks without restrictions is through online CFD brokers that offer stock CFDs. A stock CFD is a contract between the trader and the broker to exchange the difference in the price of a stock between the time a trade is opened and the time it is closed. Stock CFDs don’t give the trader ownership of the stocks, but a day trader is only interested in the price movements and not the stocks anyway.

Why day trade?

For those who have mastered the art, day trading can be a rewarding business. A good day trader can make insane returns on the capital invested, but this requires a high turnover of capital and unique skills, which only a few can boast of.

How many day traders can turn over up to a million USD in a week? On each dollar, the profit may be a fraction of a cent, so a high turnover is needed to realize a reasonable profit from the trades. The best traders probably turn over their capital once per day to benefit from the law of high numbers work for them. But before one can even think of profitability, their trading system must have a positive expectancy. If that is true, then they would want to turn over their capital as much as they can to make more money.

While it is good to master trading psychology and risk management, the first thing is to find an edge that has a statistically positive expectancy and convert it into an automated trading system. Without having a trading edge that has a statistically positive expectancy, you can never be profitable, no matter what you do. No psychological advantage can ever replace the need for a positive expectancy. There is no way to utilize the law of large numbers if you don’t have that.

Another great thing about day trading is that it involves smaller drawdowns if you manage risks tightly. Drawdowns are what make most traders and investors quit. Long-term traders and investors can watch their capital shrink by 50% if they are in the wrong market. A day trader won’t allow a single play to cause that level of damage to their account. With the use of stop losses, a good day trader can limit drawdowns to manageable levels.

Of course, there can be streaks of losses, even with the best strategies and trading systems, but a good trader can manage that by using stop losses and knowing the strategies to use for different market conditions. Moreover, by day trading, you have less risk of having adverse news going against your trades, as most news and earnings reports are released outside market hours. This might offer an advantage in risk management, even though you don’t ride the tailwind from rising asset prices.

One more benefit of day trading is the use of leverage to increase position sizes and increase potential profits. But this can only work in your favor if you have an edge with statistical positive expectancy and have a good risk management strategy. With those, you can use leverage to harness the power of day trading and make more money.

How to make money day trading

Day trading is very hard to master, as most of the daily price movements are due to randomness and noise. Only very few traders consistently transform such randomness into a big bankroll. But how do they do it? Well, the primary thing is that they have an edge and turned them into trading systems.

Successful day traders treat it like a full-time job, not merely hasty trading done between business meetings or at lunch. They spend time creating and mastering their game plans. With the way the markets have developed in recent times, it is near impossible to make money trading discretionarily. Most traders who succeed in the markets automated their strategies.

Some of the strategies used by day traders

The strategies include:

  • Scalping: Those who use this approach make numerous throughout the day in a bid to profit from small price fluctuations.
  • Range trading: Here, the trader determines the support and resistance levels in a range-bound market and uses them for their buy and sell decisions.
  • News-based trading: Trading based on the news is one popular technique. The strategy tries to profit from the high volatility that occurs around news events. Traders who use this approach focus on scheduled announcements, like the release of economic statistics, corporate earnings, or interest rate announcements, which receive market expectations and reactions. The market reacts when those expectations are not met or are exceeded, causing significant price movements that day traders try to benefit from.
  • High-frequency trading (HTF): These strategies use sophisticated algorithms to exploit market inefficiencies. They are also engaged in market making.

Note that these strategies are usually automated using trading algorithms.

Other things you need to make money in day trading

Here are some other things you can do to increase your chances of making money day trading:

  • Have a profitable trader as a mentor. This is very important; it is best to learn from someone who has been in the game and pulling out money consistently.
  • Do your research scientifically and back-test your strategies. Don’t trust any case studies because the market is full of self-glorified experts showing anecdotal evidence that often cannot hold up in a quantified test. Only quantified strategies can make you money. Do your own research!
  • Use a demo account first. Never go live with a quantified strategy unless you test it out of sample for a few months. While demo trading can never be the same as live trading where your money is on the line, it’s a good start and tool.
  • Keep a trading journal that you can review from time to time to know what you’re doing right or wrong. You most likely learn more from your mistakes. Experience is the best teacher! Ensure you record all trades so you can later go through them to see how you can improve your results.
  • Subscribe to a trading signal service. If you don’t have time to analyze the markets and create your own strategies, you can subscribe to a trading signal service like The Robust Trader.
  • Stay in touch with other traders. While most traders are very secretive and tend to keep the best ideas for themselves, you might get to learn new perspectives you’ve never thought of from discussing with other traders.

Can day trading be profitable?

Yes, day trading can be profitable if you know what you are doing. By this, we mean that you have a back-tested trading strategy with statistical positive expectancy and that you forward-test it on a demo account to confirm that it can make money in the present market condition before betting your money on it.

Moreover, you must have a reliable risk management strategy. Since the market conditions often change, you need to also have a trading plan that specifies when you review and tweak your system to remain profitable or move to a strategy that suits the current market condition.

However, in practice, only a few retail day traders are making money through day trading. A 2010 study by Brad Barber at the University of California, Davis, suggests that only 1% of day traders consistently earn money over a 14-year period, from 1992 to 2006.

The reason for this is that day trading is a skilled profession, like surgery. It takes time and grace to master. This is why the very few who make money consistently are those who devote their days to the practice and made it a full-time job. If you take your time to learn and master the art, you can be profitable.

How to develop a day trading strategy?

Different traders have their unique approaches to day trading. But the general steps for creating a day trading strategy include the following:

  • Finding a trading edge: The only way to find an edge is by researching the markets and brainstorming trading ideas. You can read financial publications and discuss with other traders for ideas.
  • Converting the edge to a trading strategy: When you find a marked inefficiency that provides an edge you can exploit, the next thing is to formulate trading rules (for trade entry and exit). This converts it into a trading strategy.
  • Coding the strategy to a trading system: Now, you code your strategy into a trading algo.
  • Back-testing the trading system: You test your algo in past market data to see how it performs and if you need to optimize it.
  • Forward-testing it on a demo account: Deploy the system on a demo account to see how it performs in the current market condition.

Day trading strategy (backtest and example)

A backtest of a day trading strategy is coming soon.

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