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Apr 20, 2022

Day Trading Rules: What You Should Know

By Team Stash
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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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