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 have the discipline to follow the rules.
Sometimes, in the heat of battle, traders will throw out their rules and play it by ear -- usually with disastrous results.
Although there are many rules, the following are the 10 most important:
1. Know your 3 E's: enter, exit, escape
This is the first rule for a reason. Before you press the "enter" key to execute a trade, you must know at what price to get in, when to get out and what to do if the trade doesn't work out as expected.
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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. Refrain from trading until 15 minutes after the market opens
Those first 15 minutes of market action are often a time of panic trades or market orders placed the night before. Novice day traders should avoid making moves during this time, while looking for reversals. If you're looking to make quick profits, it's best to wait until you're able to spot rewarding opportunities. Even many pros avoid the market open.
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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 price doesn't necessarily mean the trade will be 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 at which you'll sell. You set the parameters.
4. 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. That means a trader with a $30,000 trading account will 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. Some people cashed in their 401k's or borrowed bundles of money to finance their trades. When a major bull market ended in 2000, many of those traders' accounts were devastated. The bottom line for novice traders: 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.
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