What is Day Trading?
Day trading, is trading only within a day, i.e. all positions are closed before the market closes for the trading day and the traders who participate in day trading are called day traders. In other words, day trading involves buying and selling financial instruments within a single trading day, in which day traders close their positions at the end of each day and will start afresh at the start of the next day. Day trading is also seen as a quick method of trading, which is in contrast with the well thought strategies of long-term trades. Day trading, when started, was exclusive to financial terms and professional speculators only and most of the day traders were either bank or investment firm employees working as specialists in equity investment and fund management. However, with the invention of electronic trading and margin trading, nowadays, more and more individuals are actively participating in the same. While it sounds simple, day trading is not meant for the part timers because it demands time, focus, dedication and a specific mindset, fast decision making, while you make money by executing fairly large number of trades for a relatively small profit each time.
Some of the common examples of day traded financial instruments are stocks, options, currencies, and a host of future contracts such as equity index futures, interest rate futures, currency futures and commodity futures. During its early days, the financial settlement involved in the day trading was quite long because of the method involved in it. For example, before the early 1990s at the London Stock Exchange, the payment to the concerned party use to extend up to 10 working days after the share was bought. However, today, to reduce market risk, the settlement period is typically two working days. The main intention behind reducing the settlement period is to reduce the likelihood of the default, which was otherwise impossible without the electronic medium.
Like any other trading method, day trading also has its share of profits and risks and mainly because of financial leverage and rapid returns involved in day trading, it can range from being extremely profitable to extremely unprofitable and high-risk profile traders can generate either huge percentage returns or huge percentage losses and because of this risk involved in the same, the traders trading in it are also known as bandits or gamblers by other investors. Presence of one of the following items make
day trading a high-risk trading activity:
- Incompetent money management.
- Inadequate risk capital with the accompanying excess stress of having to “survive”.
- Trading a loser’s game/system rather than a game that’s at least winnable.
Day traders think very different from investors and use large number of strategies, such as mean reversion strategy, trend trading, swing trading, scalping, money flows etc.
1. Trend Trading
Trend traders try to make money by studying the direction of asset prices and buying or selling depending on which direction the trend is taking. If the trend is upwards and prices are making a succession of higher highs, then traders take a long position by buying, otherwise they opt for selling.
2. Swing Trading:
Swing traders look to make money from the up and down movements that occur in a shorter time frame.
This theory is based on the fact that you can just as easily build a big trading account by taking smaller profits time and time again as you can by doing fewer trades and letting profits run and it is a strict exit strategy because losses can very quickly counteract the profits.
4. Mean Reversion:
This particular strategy looks for assets that are priced furthest away from their historical means and looks to take advantage.
5. Money Flows:
This strategy uses the money flow indicator which signals whether an asset might be oversold or overbought and it uses volume and price rather than the price alone.
Taxes on Day Trading
Despite having thousands of pages of tax law there is no definitive answer as to how a trader should tax his profits derived from day trading and not to mention that its challenging and rewarding nature give rise to challenging questions about how to tax the profits a day trader makes from day trading.
Each day trader’s trading activities are individual and specific to them. Whilst one day trader trading FOREX will be given clearance by HMRC confirming that their day trading profits are not taxable; another day trader trading FOREX may be deemed by HMRC to be carrying on a self-employed business, which is taxable. Along with the trader’s activity, the financial instrument which is being traded, for example FOREX, shares, Bitcoin or another financial instrument, is also considered while determining in a day trader’s tax status.
To confirm your tax status as a day trader, you need to write to Her Majesty’s Revenue & Customs (HMRC), to which they will respond confirming your tax status as one of the following:
- Speculative in nature and similar to gambling activities, which would mean that the profits, if any, made from day trading are not taxable and are free of income tax, business tax and capital gains tax.
- If carrying on of a self-employed trading activity, in the same way any individual carrying on a business activity is self-employed and “trading”. Self-employed individuals are liable to business tax.
- If it is done under the undertakings of a private investor, where gains and losses are dealt with under the capital gains tax regime.
And although there is no defined set of rule on how your profit as a day trader will be taxed, the way you choose to do the trading makes a huge difference. For example, in case you are trading through a limited company, profits up to £30,000 will be taxed at 21%. And any money which you draw as salary will need to be subjected to income tax and National Insurance Contributions through a PAYE scheme, considering that you will be an employee or director of the company. When it comes to withdraw your profits, you can do the same in the form of a dividend which is treated as basic tax rate paid.
In case of a sole trader, the very first £6,475 of your profit will be tax free, the next £37,400 will be taxable at the rate of 20%, the next £106,125 will be taxed at the rate of 40% and anything over and above £150,000 will be taxed at 50%. Apart from the income tax you pay on the profits, you will pay Class 4 National Insurance Contributions at the rate of 8% on the profits between £5,715 and £43,875 and at 1% on profits above that.
As they say that a successful trader cuts losing trades quickly but allows profitable trades to run, and that is an important in day trading as in any other strategy. A successful day trader will have low win rates, even below 40%, but will look to target a risk-to-reward ratio of at least 1:2 i.e. he would expect to double the money which he is willing to risk in making that particular trade.