Is Day Trading Less Risky?
by Rick Thachuk

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 altogether.

Setting Stops for Day Trades

Day traders must rely on stop orders to protect their investment and capital, as best as is possible, from price risk. As is the case when setting stop orders in general, the stop order must accommodate short-term random fluctuations yet close out a trade when prices have moved too far in an adverse direction. Setting the proper stop depends upon the win-to-lose ratio of the trading system, the average profit of a winning trade, and the cost of transaction and other fees.

For instance, if the program generates a profitable trade 2 out of 5 times and if the average profit is $500 per contract and commission and fees is $25 per contract, then average loss must be less than $292 per contract in order for the program to be profitable overall. These factors are interdependent. For example, as the average loss is lowered, a greater percentage of the trades will be stopped out at a loss and this will affect overall profitability. Several months of paper trading should be sufficient to determine the stop price that results in the greatest expected profit of the trading system.

One of the mistakes made by retail day traders is in thinking that price risk can be minimized by using tight stop orders (having a stop price that is very close to the entry price) that risk, for instance, less than $100 per contract. For most of the major liquid markets, this represents only a few ticks and in some cases, is barely sufficient to cover the cost of the bid-ask spread. In the 30-year bond market, the spread is usually one or two ticks valued at $31.25 to $62.50, respectively, per contract. With the S&P 500, the bid-ask spread can fall between one-tenth of a point and one half of a point valued at $25 to $125, respectively, per contract. A stop order that only accommodates an adverse price movement of only 3 ticks in the bond market, for example, requires that the trader buy within three ticks of the low (going forward) or sell within three ticks of the high (going forward). It is unrealistic to expect this caliber of trading performance systematically. The result is that stops will be elected almost continuously and the trading capital will slowly but surely dwindle. In addition, the stop order will incur slippage making it even more unlikely that risk can be constrained to under $100 per contract especially during volatile periods.

Even though price risk exists for a shorter period of time for the day trader as opposed to the position trader, the inability to use options and the higher cost of slippage on stop orders relative to open equity loss of a trade can make this price risk more difficult to manage. But the story does not end here. Transaction risks become more acute for the day trader compared to the position trader.

Transaction Risk

With every transaction to buy or sell, there are risks involved. These risks are faced by both the day trader and the position trader and include:

* Mistakes made by the trader in entering the order.
The consequences are fully borne by the trader.

* Mistakes made by the broker in filling the order.
This includes lost orders. In some cases the consequences are borne by the broker but more commonly, the consequences are borne by both the broker and the trader. The latter may be true, for instance, if the trader upon placing the order verbally confirms the order when read back by the broker, even if it was recorded and read back incorrectly.

* Trades that were correctly filled but placed in the wrong account.
This is easily corrected by the broker without cost. However, it will become a problem if the trader acts on this information. That is, if the trader makes another trade believing that the previous one was lost, then he will bear the consequences of that trade, even after the lost trade is correctly placed in his account.

* Change in price or quantity of reported fills.
It sometimes happens that reported fills are later adjusted in price or quantity. This is a result of mismatch order correction among the executing floor brokers at the end of the day. The consequences are fully borne by the trader.

* Delays in reporting fills.
Imagine that you have a long position in the market and you are not sure if your protective stop has been filled. The market closes in five minutes. It has been a volatile day with high volume in the pit. You call the desk for an order check on your stop and they tell you, “Nothing back”. This means that your stop order may or may not have been filled. What do you do? In short, there is little you can do. This uncertainty causes much more anxiety and has higher potential cost to the day trader than the position trader. Included in this category is the risk associated with canceling an order, subsequently transacting as if it was canceled and then later discovering that the order was filled because it was too late to cancel.

* Inability to transact.
The transaction may not be able to be executed at the desired price because of market illiquidity, or because trading has been suspended by the exchange (during especially volatile conditions), or because the market has become locked limit.

* Failure to transact.
The day trader must offset positions prior to the closing bell or else be prepared to carry positions overnight. Failing to transact prior to the day’s end can be costly to the day trader and can occur for several reasons. There is always a risk that the trader will become distracted throughout the day and forget to offset positions in time. Communication-related problems could also prevent the trader from executing a necessary transaction. Also, there may be times when the market closes early (prior to an official holiday) and the trader, being unaware of this, failed to transact in time to offset positions. Failing to transact in time will necessitate that the day trader hold a position overnight and possibly over a weekend. Not only does this expose the day trader to additional price risk, but the trader may not have sufficient capital to meet margin requirements for carrying the position overnight.

A day trader will execute more transactions than a position trader over the same time period and so will face these risks much more often than a position trader. Moreover, the day trader is usually constrained by time when problems do arise: errors must be identified and corrected before the trading day ends. Any resulting loss is likely to be significant to the day trader who operates with less financial flexibility than the position trader.

Tips to Manage Risk of Day Trading

Some of the risks mentioned above cannot be readily managed so their expected cost must be factored into a day trading program. Others, however, can be reduced by following these simple steps:

1. Trade liquid markets only. Prices will be current and fills will be executed quickly and are more likely to be reported back in a timely manner.

2. Acquire a real-time price data feed. This will enable you to accurately monitor the market.

3. Enter transactions on-line to reduce recording errors and increase the speed in which fills are reported but only if you feel comfortable doing so. Some traders feel more comfortable and confident transacting over the telephone. If trading by computer, make sure you have a phone number to the trading desk in the event that the computer or internet link is down.

4. Enter transactions well before the market closes so as to provide sufficient time to resolve any problems that arise.

5. Secure access to the overnight market for use in an emergency to close a trade.

6. Avoid trading around the time of release of important news or numbers. For instance, the bond market can react violently immediately following the release of the employment numbers and the trader risks significant slippage on stop orders if the price movement is adverse.

7. Avoid markets with price limits. If the day trader does get stuck on the wrong side of a limit move, they can purchase an option to provide some price protection. Option markets will continue to trade even when the futures is locked limit. The trader should be aware that implied volatilities will be high in this case and option premiums will be costly.

8. Make sure you have the time to devote to your day trading. Day trading often requires constant supervision of the markets. Moreover, with constant monitoring, any transaction errors can be identified and resolved.