Online trading technology is so advanced that you can do just about anything from the comfort of your own home. Day trading is one of the most common trading approaches, and if you want to start, Benzinga is here to show you how. Not only this, but we’ll also cover the five most important rules you’ll need to know to give you a leg up on your day-to-day adventures with the stock market.
- Overview: Day Trading Rules
- Rule 1: You’ll Need to Abide by the Pattern Day Trader Rule
- Rule 2: Day Trading Accounts Operate on Margin
- Rule 3: Day Traders are Subject to Specific Requirements
- Rule 4: Don’t Trade with Money You Cannot Afford to Lose
- Rule 5: Be Ramiliar with the Risks
- Rule 6: Aim for Steady Growth
- Final Thoughts
Overview: 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 of time, day traders speculate 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.
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 rules for pattern day trading 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 in order to complete your training. Pattern day traders 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 bigger returns. 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 $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 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 requirement.
Rule 4: Don’t Trade with Money You Cannot Afford to Lose
Avoid putting your savings or your child’s college fund into day trading activity. Your funds should be explicitly assigned for trading.
Rule 5: Be Ramiliar 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. 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. 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.)
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.