Day trading has become more popular among retail traders over the last several years primarily because of the affordability of real-time prices (many on-line trading accounts now provide real-time prices free of charge), the availability over the Internet of free intra-day graphs, such as 10-minute bar charts, and the emotional and financial appeal of finishing every day and starting every weekend with no market exposure. Moreover, because margin requirements for day trading are reduced, in some cases effectively close to zero, traders with small-sized accounts can afford to day-trade some of the more expensive contracts such as the 30-year bond and even the S&P 500 contracts. The assumption made by most retail traders is that day trading is less risky than traditional position trading where contracts may be held for several days or weeks. While it is true that day trading eliminates overnight price risk (because positions are closed or offset at the end or prior to the end of every day), there are other factors that, when considered collectively, can make day trading a riskier proposition. The retail trader who is contemplating starting a day-trading program should be aware of these risks and how to manage them, where possible.
Price Risk The price risk of day traders, by definition, exists only during the day. The position trader, on the other hand, assumes in addition the price risk overnight and often over the weekend. This does not necessarily mean, however, that the day trader can more easily manage price risk than the position trader. One reason for this is that position traders can incorporate options into their trading strategy to help manage price risk. Indeed, for every debit option trade (option purchased), the maximum risk is known and fixed regardless of price movements during the day or overnight. When day trading, however, option-related strategies are undesirable for price risk management for several reasons. (Floor traders who are physically located in the trading pits of the exchange, on the other hand, may be able to use options to manage the risk of their day-trading activity. Please see the insert "Day Trading on the Exchange Floor".) Option markets are typically less liquid than the corresponding futures market meaning that prices may not reflect market value, orders may take longer to fill and to be reported back to you, and the cost in terms of the bid-ask spread is higher. Moreover, except for deep in-the-money options, options will not move as much as the corresponding futures contract and this eliminates the motivation for day trading options from a potential profit perspective. From a risk management perspective, the impracticability of incorporating option strategies into a day-trading program requires that the retail trader rely solely upon a less effective risk management tool: stop orders. The risk of slippage associated with stop orders is well known to all traders but becomes more acute for the day trader.
Day Trading on the Exchange Floor
Floor traders who have immediate access to the futures and the corresponding options trading pit of a market are best positioned to execute day trades quickly and effectively. They are the first to receive any information originating from the pit. Of course, floor traders pay for this privilege: to stand in the trading pit requires that you buy or lease a membership. Memberships range from $50,000 to over $1 million dollars depending upon the exchange. Floor traders who accumulate large positions in their day trading activity can use options to manage (hedge) their price risk. They do this by buying or selling options so that the net delta of their portfolio at the end of the day is zero. The delta of a position refers to the dollar change in its price for every dollar change in the price of the underlying futures contract. Consider the sample prices of the June 30-year bond options below.
30-Year U.S. Treasury Bonds
June Futures last trade price: 94-15
Call Options Put Options
Strike Price Delta Strike Price Delta
96 1-17 +.38 96 2-49 -.60
94 2-11 +.50 94 1-46 -.45
92 3-28 +.69 92 1-00 -.30
Say, for example, that the end of the trading day is approaching and that the day trader is long three June bond futures that were purchased throughout the day. Being long three futures generates a net portfolio delta of +3.0. To square the position until the next morning, the trader could sell the three futures which returns the net delta to zero. As an alternative, the trader can use options to reduce the net delta to zero, specifically by buying put options or by selling call options. Based on the option prices above, the trader can keep the three bond futures and hedge the price risk by buying five of the 96 put options. Since each put option has a delta of -.60, five of them have a combined delta of -3.0 and this will exactly offset the delta of the futures and bring the net portfolio delta to zero. Similarly, the trader could instead purchase ten of the 92 puts, or sell six of the 94 calls. (Buying a call option generates a positive delta and selling a call option generates a negative delta.) Determining which of these options to buy or sell depends upon relative prices at the time. That is, the floor trader will buy options that are undervalued in price or sell options that are overvalued in price. Such mispricings are short lived making this strategy tenable only to the floor trader.
Stop orders are notorious for being filled at a less desirable price than that specified in the order. This slippage usually amounts to a tick or two but can be significantly more under inordinately volatile conditions. Neither the day trader nor the position trader has direct control over the slippage of a stop order and so both must equally bear this risk. During some instances, the better the executing broker in the pit, the less the slippage. However, the retail trader - whether day trading or position trading - cannot realistically expect to have any control over who is the executing floor broker. (Please see the insert "Setting Stops for Day Traders".) Even though both must bear the risk of slippage of stop orders, the relative cost of this risk is not the same. For position traders, the dollar value of the slippage relative to the open equity loss on the trade is typically small because the position trader initially sets a higher permitted loss than the day trader. For instance, the position trader may set an acceptable loss of $800 on a bond trade (and has allocated even more cash in margin to cover possible further loss) while the day trader may accept a loss of only $200. A one-tick slippage in the bond market (one tick has a value of $31.25) increases the cost to the position trader of 4% and to the day trader, a much higher 16%. The relative cost of slippage can cause some day trading programs to become unprofitable in certain markets (for instance, those that are less liquid and have wider bid-ask spreads). Moreover, in those unusually volatile periods, unexpectedly high slippage has the potential to seriously damage the long-term return performance of a day trader and can even wipe out a significant percentage of trading capital. An all too common investment track record of a retail day trader is to have a series of alternating small-sized winning and losing trades terminate in one unexpectedly large losing trade - after which the trading typically stops