Suitable Instruments for Day Trading

Basic Criteria

What basic characteristics should an instrument have in order to make it a suitable candidate for potential day trading? In our view, the most important attributes are:

Liquidity
Volume
Volatility
Price Transparency

Each of the above attributes will be discussed separately below.

1. Liquidity

Liquidity, broadly defined, is the existence of a sufficiently large number of buyers and sellers in an instrument to permit one to quickly and easily acquire or exit a position in the instrument. Good liquidity is important to the day trader who requires fast executions at relatively predictable prices. High liquidity also has the additional advantage of (generally) reducing the bid-ask spread for a particular instrument therefore reducing execution costs for the day trader. There is no quantitative measure of liquidity. Liquidity is based on a number of factors, the most important of which are:

Volume of transactions on the market (the higher the better)
Number of contracts/share outstanding (the more the better)
Breadth of ownership ( the higher the number of traders the better)
Number of market makers (the more the better)

2. Volume

Volume is a component of liquidity and is easily measurable. A good day trading instrument should trade at least 500,000 shares a day and preferably much more. instruments with high volumes permit the day trader to acquire or sell a large quantity of instrument without unduly affecting the price of the instrument.

3. Volatility

Volatility refers to the actual or expected price movement of an instrument (either up or down) over a particular period of time. In the case of day trading, the period of time to look at is a single day. instruments which tend to exhibit little movement in price during a typical trading day are not good candidates for day trading. A good rule of thumb is to select for trading only those instruments which tend to fluctuate in price substantially in a typical trading day.

4. Price Transparency

Price transparency refers to the ability to obtain information as to the order flow for a particular instrument. This is also referred to as market depth.