Day Trading and Buying Power

The size and scale of positions that a day trader enters into is affected by the day trading buying power allowed by the firm being traded with. In other words, account value and buying power can be different numbers. Many day trading firms will extend their traders buying power leverage based on the amount the trader has available to trade. For example, a 20 to 1 leverage policy would mean that for every $5,000 invested in a trading account, the firm would allow positions held to be worth up to $100,000.

The Drawbacks of Leverage

While this allows for the potential of large profits, this apparent buying power is often the demise of traders because it provides a false sense of scale. If you have only $5,000 in an account, once the position is down by $5,000, your account is wiped out. For example, if you own 1000 shares of a stock at $50 per share (which is a $50,000 investment and within the limitations of a buying power of $100,000), and the stocks drops five points, you are down $5,000. If this was your initial investment, the account will close unless more money is deposited. Consequently, this artificial buying power creates limitations when attempting to cost-average effectively.

Changing Nature of Day-Trading

Over the past few years, it has become increasingly difficult to earn consistent profits through day trading due to the structure of the open book as well as increasing trading commissions. Hidden orders now often cause significant and instantaneous swings in the price of a stock, which makes it difficult to adhere to risk-reward frameworks. This is especially true when a trader is willing to risk only a few cents before cutting the trade. Day trading by building effective cost averages and having confidence in the price level of the stock may be one of the only ways to still successfully practice the craft. This strategy requires sound research, proper scale and great timing in order to achieve consistent results.

Real Buying Power Relates to Scale

The scale necessary to build profitable positions relates to the amount of personal buying power a trader has relative to the amount of shares being traded. If a trader has only $5,000 to trade with and initiates positions in 100-share lots, he will be able to cost average only a few times before being forced to cut the trade if the equity continues to go against him. However, if the trader initiates positions in only 10-share lots (or 100-shares lots with $500,000+ personal buying power), a stock’s cost can be lowered dramatically, bringing, for example, the cost basis of a stock that was initially $50 down to $20 or $15. This increases the chances for profit anytime the stock kicks up, and this type of scale is vital to successful cost-averaging on an inter-weekly basis. A major problem with buying power provided by trading firms is the false sense of security of having this type of scale, when, in fact, the trader is trading in 100-share lots with only five or ten thousand dollars.

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