Day trading consists of quick purchases and sales of stock throughout a day with the goal of making a fast profit. Day traders hope to earn a profit through a value increase or decrease in the seconds or minutes that they own a stock. Most day traders purchase stocks on loaned money because they intend to gain significant profits through higher-risk investments.
Although day trading is not illegal, it is a high-risk trading strategy. Day trading requires wealth, time, and the right temperament in order to make money and also survive the significant potential losses.
What Are Day Trading Rules?
There are many day trading rules that investors need to be aware of when trading. Failure to follow many of these rules could result in considerable costs. Although some rules can vary based on location and the number of trades made, the following are the most important rules that apply to day trading and also pattern day trading:
- Wash-Sale Rule
- Account Rules
The wash-sale rule is an important rule that applies to day trading in the U.S. This rule is enforced by the IRS and it prevents traders from claiming a loss on a stock in a wash sale.
A wash-sale happens when an investors trades a stock at a loss and then purchases an almost identical stock within thirty days of the loss. This rule also applies to spouses and any company owned by the investor. Any loss on a wash-sale has to be added to the cost of the new stock per the IRS.
While some day trading rules apply specifically to stocks, futures, options, etc, most rules are primarily based on the investor’s account and broker. Brokers typically offer a variety of accounts such as margin accounts and cash accounts. These types of accounts often come with their own set of rules that traders must adhere to.
The following are a few rules to look for when choosing a broker:
- Minimum deposit
- Daily trading limit
- Margins and leverage
The minimum deposit required when signing up with a broker can vary from broker to broker. Some brokers require a significant amount of capital while others have a lower minimum. It is usually recommended that new traders look into brokers with a lower minimum deposit requirement.
The daily trading limit rule will also vary among brokers. The purpose of this rule is primarily to shield the market from extreme volatility and manipulation; however, it also helps to minimize investors’ losses.
If you open a cash account, then the rules prevent you from loaning capital from your broker; however, if you open a margin account, you will be allocated a set amount of borrowed money that you can use for trading. Rules regarding the amount of margin you receive depends on your broker.
What Is A Pattern Day Trader?
One of the most important rules of day trading is whether or not you are considered a pattern day trader. If a trader makes over three trades within five business days that exceed 6% of the trades in his or her account, then the minimum criteria has been met to be considered a pattern day trader. Pattern day trading rules apply to all pattern day traders in the U.S. with a margin account.
Additional rules and regulations that apply to pattern day traders are as follows:
- Minimum account balance
- Buying power
- Minimum Requirements
- Existing sale conditions
- Outstanding margin call
- Failure to meet margin call
The most difficult rule to meet is the minimum account balance rule also known as the PDT rule. All pattern day traders must have an account with a balance of at least $25,000. While this amount cannot be met through cross-guaranteeing different accounts, it can be met by combining cash and securities.
The buying power of a pattern day trader is equal to four times the New York Stock Exchange excess at the end of the previous business day. The time and tick method of counting day trades is allowed. If this buying power is exceeded, then a margin call will result.
When money has been deposited into an account for a minimum equity requirement or a margin call, it must stay there for a minimum of two business days before it can be withdrawn.
When it comes to pattern day trading, it’s also important to understand that the sale of an existing stock that was purchased on a previous day is not a day trade and will not be applied to the minimum trade requirement.
If an investor’s account has an outstanding margin call, then the buying power will decrease to two times the New York Stock Exchange excess. In addition to the reduced buying power, the time and tick method is no longer an acceptable method for calculating day trades, therefore, the aggregate method will be used in its place.
If an investor fails to meet an issued margin call within five business days, then the buying power is lowered even more to only one times the New York Stock Exchange excess. This reduction is in place for ninety days or until the call has been met.
Advantages and Disadvantages of Day Trading Rules
Although pattern day trading comes with strict rules, its account does come with the advantage of leverage. Day traders that do not have a pattern day trading account can only hold positions that total two times the account balance while pattern day trading accounts can usually get twice that amount. Pattern day trading accounts also have the potential to provide a serious profit because the buying power is determined at the start of the day.
While the profits can be maximized with a pattern day trading account, the losses can also be significant. It’s possible for traders to lose more than their original investment or even have their positions liquidated by their brokers.
Another aspect of day trading to watch out for is that it’s difficult to lose the title of a day trader. If traders receive training from their broker, then they will likely be labeled as a day trader. This means that they need to be prepared to follow the day trading rules right from the start.
Due to the practice of “reasonable belief” based on previous activities, day traders will likely not lose their title unless they contact their broker with a request to have their account changed and be granted freedom from the day trading rules.
Tips for New Day Traders
The following tips are especially important for day traders that are new to the business:
- Make a game plan.
- Perfect the timing.
- Be cautious of the margin.
- Utilize a demo account.
- Accept the possibility of a loss.
- Continue to learn.
- Thoroughly evaluate any advice given.
While starting off on this crusade can be quite exciting to new traders, it is crucial that traders have a plan before entering a stock. If trades aren’t carefully evaluated and planned, traders could end up out of the game before they even get a chance to enjoy it.
Trading is all about the timing. A key trading rule to put into practice is to stay away from the market for the first 15 minutes that it’s open. The first 15 minutes is usually filled with last-ditch trades or old market orders. Rather than entering positions, traders can use those 15 minutes to search for reversals or other strong trades.
A margin can be extremely tempting when starting off, but it is important to remember that you will have to pay back the loan at some point. Yes, the margin can significantly improve your profits, but as mentioned previously, it can also increase your losses. For this reason, it is highly recommended that traders know how to trade successfully before utilizing margin.
The idea of learning how to trade well brings up another key tip in the form of demo accounts. Demo accounts offer an unlimited no-risk practice using fake money. Many brokers provide a free practice account. These practice accounts can be key to getting a feel for the charts, patterns, and strategies that you’ll be evaluating when trading.
It’s important for traders to not only accept loss but embrace it. Many experienced traders got to where they are because they embraced their losses; however, there’s a fine line between accepting loss and minimizing it. Risk management is also an important part of the process.
One thing top traders never do is grow complacent. There is always room to train and grow, therefore, it’s key to utilize all of the various resources that are out there for traders to gain more knowledge and improve their skills.
Lastly, while everyone loves to receive helpful tips, false tips can lead to serious losses. This is why it’s important that you double-check any and all tips and above all, trust your own judgment.
Know Your Day Trading Rules
Day trading can be extremely profitable, but it can also lead traders down a road of extreme loss. If you’re looking to jump into the day trading game, you want to make sure that you have a full understanding of the rules so that you can start off strong. As mentioned, one of the best ways to learn and grow is by utilizing the many resources out there.