Day trading can be an exciting and potentially profitable venture. But it's not as simple as just buying and selling stocks throughout the day. There are specific day trading rules and strategies that every day trader should be aware of in order to maximize their chances of success.
To navigate the world of day trading successfully, it's crucial to familiarize yourself with the essential rules and principles. These rules will not only help you protect your capital but also increase your chances of making consistent profits.
In this article, we will explore the key day trading rules that every aspiring day trader should know and follow. You'll also learn the six most important rules you’ll need to know to give you a leg up on your day-to-day adventures with the stock market.
What are Day Trading Rules?
Day trading is a high-risk trading style in which you purchase and sell financial securities on the same day. Unlike standard investors who buy and own financial assets for lengthy periods, day traders speculate on the price of financial assets without actually owning them. Since trades are open and closed intraday, they aim for small price moves.
These moves will not make much of a change to your bankroll if you trade with your own funds, so day traders rely on borrowed money (trading on margin) to conduct trades. Though highly speculative, margin trading allows traders who don’t have the obligatory cash on hand to day trade.
6 Key Day Trading Rules
To thrive in the world of day trading, it's crucial to adhere to a set of fundamental rules. These rules can help you navigate the unpredictable market and increase your chances of success. Whether you're a novice trader or have been in the game for a while, it's important to assess whether you're following these key day trading rules.
Rule 1: You’ll Need to Abide by the Pattern Day Trader Rule
You’re considered a pattern day trader by the Financial Industry Regulatory Authority (FINRA) if you execute four or more trades in a five-day period. Pattern day traders must have 6% of these trades in the same margin account for that same five-day period.
Certain day trading brokers might have different requirements to qualify you as a pattern day trader. Contact your agency to determine the exact pattern day trading rules before opening an account.
Example: You participate in a broker’s day trading courses for pattern day trading and the broker can give you an account to complete your training. The pattern day trader rule states you must maintain a minimum account equity of $25,000 and are always bound by margin.
Rule 2: Day Trading Accounts Operate on Margin
Margin means you not only leverage your own funds but with extra funds that you borrow from your broker.
These funds offer you greater buying power, and you can aim for more significant returns. However, the inherent risk involved in margin trading means that one bad trade can result in a severe loss of your own funds. For example:
- You have a $225,000 account for live day trading
- You trade on margin with a leverage of 4:1
- You can trade with only $200,000 in order to comply with equity requirements
- 4 x $200,000 = $800,000 total buying power
- Your strategy puts 20% of your buying power in a single trade = $160,000 per trade
If the price of your financial asset goes against you with 5%, you will lose real money equal to:
- $160,000 * 0.05 = $8,000
- This is an $8,000 loss from a single trade. So, what is the maximum negative move you can handle?
- $160,000 * X = $200,000
- X = 200,000 / 160,000 = 1.25 or 125%
- Since financial assets cannot lose more than 100% of their value, you cannot lose all your funds with this strategy. However, you can still lose the investment in the trade, which is 80% of the $200,000.
If you are not able to meet your broker’s requirements financially, you will get a margin call. Your broker will alert you to provide more funds, or your trades will be instantly closed on a loss.
It’s important to follow strict money management rules to avoid such a scenario. You can always limit your risk with a stop-loss order. If you limit your losses to 1% per trade, it’ll take 100 losing trades to fully wipe out your account. Let’s do some math again.
- You have $200,000 available for trading. One percent risk per trade is $200,000 * 0.01 = $2,000
- You want to limit your loss to a maximum of $2,000 per trade. Thus, we need to calculate how much $2,000 is from the amount you invest in a single trade ($160,000)
- 2,000 / 160,000 = 0.0125, or 1.25%
- With the above conditions, your stop-loss order should be at a distance of 1.25%. If a stock trades at $250 per share, your stop-loss should be at a distance of $250 * 0.0125 = $3.13
Rule 3: Day Traders are Subject to Specific Requirements
According to FINRA, a day trader will be subject to the following requirements:
Your equity is your absolute account value, including any profit or loss from open trade. A day trader needs to make a minimum deposit of $25,000 and maintain a minimum equity of $25,000 all the time.
The minimum equity can contain both cash and securities. Note that your broker can always impose higher equity requirements.
You can trade up to four times more on the maintenance margin excess. Your brokerage firm can apply changes to this rule.
Your buying power is the maintenance margin excess times the margin you are using. If your excess is $50,000, then your buying power will equal $50,000 * 4 = $200,000.
You get a margin call when you are unable to meet your brokerage account requirements. This could be fatal for your account as your trades can get closed on loss if you don’t comply. You will get a margin call if you exceed your buying power limitation. Then you will have up to five business days to deposit funds to meet the margin account requirement.
Rule 4: Don’t Trade with Money You Cannot Afford to Lose
Trading with money that you cannot afford to lose can lead to emotional decision-making and increased stress, which can negatively affect your trading performance. When you are trading with money that you need for essential expenses or financial obligations, you may become overly anxious and make impulsive decisions that are not based on sound analysis or strategy. into day trading activity. Your funds should be explicitly assigned for trading.
Rule 5: Be Familiar with the Risks
Three different risks related to trading:
You Can Lose Everything on a Single Trade
Successful day traders have many losing trades in addition to winning trades. Therefore, every trade needs to have a stop-loss order or security to limit your potential loss for every trade.
You need to know how much you will lose and what you will have in case the market runs against you.
If you’re a day trader, bankruptcy is a non-remote possibility, which will cost you all the money in your trading account and could saddle you with extra debt. Make sure you stay familiar with the trading conditions of your broker and the eventual outcomes in case you fail.
Broker Financial Failure Risk
What happens if your trading provider fails to meet its financial obligations and goes out of business? Some reputable companies guarantee you a certain amount of money in case they go out of business.
Rule 6: Aim for Steady Growth
Many beginner traders believe they will profit big-time right away, maybe popularized by the Hollywood movies we watch every day. But, in reality, most traders are out of business not long after they begin day trading.
Your goal is to grow on a consistent basis, and a successful amount could even be 2% per month.
Example: Imagine you have a $100,000 account and you grow it by 2% every month. At the end of the year, you would have $124,337. (Most investments will not return a 24.34% yearly interest.)
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Creating the Optimal Trading Plan
More than 80% of day traders aren’t successful, and it’s easy to see why. Clearly, day trading comes with a harrowing set of rules and requirements, but meeting these requirements is not enough to be a successful day trader.
You’ll first need to build a working trading strategy and then apply proper money management rules. Take into consideration minimum equity requirements, margin, buying power and the amount you use in one trade.
Want to learn more? Check out Benzinga's guides to the best day trading brokers, best day trading software and best day trading books. Also, if you're just getting into day trading, learn how to day trade with only $100.
Frequently Asked Questions
How many day trades can you make in a day?
The number of day trades you can make in a day depends on your account type and the regulations set by the financial authorities. For most individual traders with a standard margin account, the Pattern Day Trader (PDT) rule applies, which limits them to three day trades within a rolling five business day period. However, if you have a higher account balance or meet certain criteria, you may be eligible for a higher day trade limit. It’s essential to consult with your broker or financial advisor to understand the specific rules and limitations that apply to your situation.
Why do you need $25,000 to day trade?
You may need $25,000 to day trade because it is a requirement set by the Financial Industry Regulatory Authority (FINRA) for pattern day traders. This rule was implemented to protect inexperienced traders from potentially risky trading practices. By having a minimum account balance of $25,000, it is believed that traders will have a better understanding of the risks involved and be more likely to make informed decisions. Additionally, the higher account balance allows for greater flexibility and the ability to take advantage of market opportunities.
What happens if I'm flagged as a day trader?
If you are flagged as a day trader, it means that you have executed multiple day trades within a short period of time. This classification comes with certain restrictions and requirements set by regulatory bodies. Depending on the country and specific regulations, being flagged as a day trader may result in limitations on your trading activities, such as increased margin requirements, restricted access to certain markets, or even the suspension of your trading account. It is important to understand and comply with the rules and regulations surrounding day trading to avoid any potential consequences.