Home / Investing / Day Trading Rules: What You Should Know
Investing
Apr 20, 2022
By Team Stash
In this article:
If you’re curious about day trading, you’re not alone: There’s no shortage of day trading evangelists who claim to know the secret to beating the market. However, the reality is more complex. Day trading comes with some serious risks, and it’s regulated more strictly than other types of investing. Learn the day trading rules to understand how it works.
What is day trading?
Day trading is buying and selling the same stock during a single day using a margin account. Unlike a cash brokerage account, which is funded with your money only, a margin account allows you to take loans from your brokerage. That’s called “trading on margin” or “leverage.”
Theoretically, leverage multiplies your resources so you can buy and sell more shares, and potentially make a bigger profit. Of course, you’ll have to pay back the loan, plus interest and fees.
But leverage also multiplies any losses you may incur. You can lose your own money plus end up owing the brokerage money too, potentially much more than you invested.
How does day trading work?
Day traders look for securities with prices that bounce up and down every day. Then they make bets about whether the value will rise or fall within an afternoon, or even over the course of a few minutes. Based on those bets, day traders buy stocks and sell them the same day.
Ideally, the day trader guesses right, making many small profits that add up. Predicting price changes, however, is exceedingly difficult, even with high-tech software. Losses are common. Trading on margin amplifies the risk, because any loss quickly multiplies.
Because day trading is very risky, people who day trade regularly must follow special day trading rules.
What is a pattern day trader?
Regular day traders are called pattern day traders. If your brokerage determines that you’re a pattern day trader, you’ll be subject to day trading rules.
In general, you’ll be flagged as a pattern day trader if your trading activity matches the following:
- You make four or more trades in one day
- You make day trades within five business days
- The number of day trades is more than 6% of the total trades in your margin account for the same five business days.
Brokerages are required to designate you as a pattern day trader if they have a reasonable belief that you engage in pattern day trading, even if you don’t fit the above criteria exactly. For example, some brokerages offer classes about day trading. If you take one, you might be flagged before you make a single trade.
Rules for day trading
Once you’re flagged as a pattern day trader, you face special restrictions.
Rule 1: Minimum equity requirement
Pattern day traders must keep at least $25,000 in cash or securities in their margin accounts when trading. The account must meet the minimum at the beginning of the trading day and stay in compliance throughout the day.
If the account falls below $25,000, the brokerage must suspend day trading until the minimum equity requirement is met. Some brokerages have higher minimums.
Rule 2: Day trading buying power
On any given day, a pattern day trader’s buying power is limited by the prior day’s account balance. According to day trading rules, a trader cannot exceed four times the maintenance margin excess at the close of the previous day. Brokerages can set stricter limits.
If you exceed the limit, the brokerage must issue a margin call: a notification that you have five business days to bring your account into compliance. In the meantime, your buying power will be reduced. If you don’t meet the call on time, you can’t trade on margin for 90 days or until the call is met.
Once again, brokerages can have more stringent rules about margin calls. For instance, they usually don’t allow trades until you’re in compliance. They can also sell securities in your account, without advance notice, to meet the call.
Should you day trade stocks?
Ultimately, you’ll have to make the decision for yourself, but here’s what the experts at the Securities and Exchange Commission (SEC) say: “Day trading is extremely risky and can result in substantial financial losses in a very short period of time.”
The Financial Industry Regulatory Authority (FINRA), which is charged with overseeing brokerages to protect U.S. investors and sets the pattern day trading rules, agrees: “Day trading can be extremely risky. Day trading generally is not appropriate for someone of limited resources and limited investment or trading experience and low risk tolerance. You should be prepared to lose all of the funds that you use for day trading.”
There’s science to back up these statements: One study on the success rate of day traders found that 97% of day traders lost money over the long term, and only 1% earned more than minimum wage.
All investing involves risk, including the risk that you can lose money. Many experts agree that day trading is one of the riskiest options out there. So if you’re considering whether you should buy and sell stocks on the same day, be aware of the risks before you take the plunge.
How to safely invest in stocks
Day traders seek quick wins, dipping in and out of the market in moments. Many experts suggest that a less risky strategy is to take a bigger-picture view: buy and hold securities over the long term, riding out the market’s inevitable ups and downs.
Diversifying your portfolio among stocks, bonds, funds, market sectors, and more, could also reduce your risk. Finally, knowing your risk profile can help you make investing choices that align with your long-term goals.
Day trading vs. investing
Day trading may be exciting to some; many proponents hype the possibilities for earning quick cash. But just like any get-rich-quick scheme, it can lead to financial loss and potentially land you in debt, even if you follow the day trading rules. Fortunately, there’s a safer way: buy-and-hold investing. With an investment strategy that takes the long view, you might have a much better chance at a brighter financial future.
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As an enthusiast with a deep understanding of day trading, it's crucial to approach this financial strategy with a comprehensive grasp of its complexities and potential pitfalls. I've actively engaged in day trading and have navigated through the intricate web of rules and regulations that govern this high-risk, high-reward activity.
Day trading involves the buying and selling of the same stock within a single day, often utilizing a margin account that allows traders to borrow funds from their brokerage—commonly referred to as "trading on margin" or "leverage." While leverage can amplify profits by enabling the trader to buy and sell more shares, it also magnifies potential losses, putting not only the trader's initial investment at risk but also exposing them to additional debts owed to the brokerage.
In the article, the concept of day trading is dissected, emphasizing the volatility of securities that day traders typically target. These traders aim to capitalize on short-term price fluctuations, making predictions about whether a stock's value will rise or fall within a brief timeframe. However, accurately predicting price changes is challenging, even with advanced software, and losses are a common occurrence. Trading on margin heightens the risk, as any losses can quickly snowball.
A significant aspect of day trading is being classified as a pattern day trader, which brings about specific regulations. A pattern day trader is identified by engaging in at least four trades within a single day on more than six percent of the total trades in their margin account over five business days. Brokerages are required to designate individuals as pattern day traders if there is a reasonable belief that they are involved in pattern day trading, even if they don't precisely meet the specified criteria.
The article outlines key day trading rules that pattern day traders must adhere to:
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Minimum Equity Requirement: Pattern day traders must maintain a minimum of $25,000 in cash or securities in their margin accounts.
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Day Trading Buying Power: A trader's buying power is limited by the previous day's account balance, with a restriction of not exceeding four times the maintenance margin excess.
Violation of these rules can lead to consequences such as suspension of day trading activities and margin calls, adding an extra layer of risk and complexity to the day trading endeavor.
The article also provides insights from regulatory bodies like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), cautioning against the inherent risks of day trading. Research findings indicate that a substantial majority of day traders incur losses over the long term, reinforcing the notion that day trading is an exceedingly risky venture.
In contrast, the article suggests a more stable and less risky investment strategy—buy-and-hold investing. This long-term approach involves holding securities over an extended period, navigating through market fluctuations with a focus on sustained growth rather than short-term gains. Diversifying one's portfolio is also recommended as a means to reduce risk.
In conclusion, while day trading may appeal to some for its excitement and potential quick gains, the article advocates for a safer and more conservative approach through long-term investing strategies, emphasizing the importance of understanding one's risk profile and aligning investment choices with long-term financial goals.
