Retail day trading was prevalent throughout the 1990s and 2000s with the introduction of online trading accounts. Since then, high-frequency trading firms have made day trading more competitive and less profitable for retail traders.
Regulators concerned about inexperienced retail traders introduced new rules designed to limit day trading to professionals. These rules have also helped to ensure that even professional day traders don’t take on excessive leverage that could interrupt the market.
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Let’s take a closer look at these rules and how they impact both retail and professional day traders.
What Is a Day Trade?
Day trading refers to the buying and then selling (or selling short and then buying) of the same security on the same day.
If you purchase a security without selling it on the same day, then the trade isn’t considered a day trade. These longer-term trades are known as swing trades or position trades, and they’re not subject to day trading rules (although margin account rules still apply).
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Day traders generate a profit by taking advantage of small price movements or by providing liquidity in exchange for ECN rebates. For example, a day trader might use a fading strategy following an earnings announcement to capitalize on the short-term overreaction and subsequent reversion to the mean.
What Is a Pattern Day Trader?
Pattern day traders use margin accounts and day trade four or more times within five business days. Brokerage firms might designate a customer as a pattern day trader based on their trading history or other factors – even if they haven’t met the technical definition of a pattern day trader.
Once you become a pattern day trader, you’re subject to the rules and regulations for as long as you have the account – even if you don’t day trade for a five-day period. However, you can contact your broker if you cease day trading and they might be able and willing to change the coding on your account.
Cash accounts are not subject to these rules, but they must adhere to another set of rules. In particular, cash traders cannot place day trades that result in free riding – or the sale of securities bought with unsettled funds. If a day trader is caught free riding, he or she will be required to pay for securities with cash upfront for 90 days.
Pattern day traders must maintain at least $25,000 in equity (cash and eligible securities) when placing day trades. They cannot use cross-guarantees with other accounts to meet these requirements, which means that the entire amount must be present in the same account as the trades are placed.
If the account falls below these levels, the broker will place a day trading minimum equity margin call on the account. The trader has five business days to meet the margin call. Otherwise, the trader’s buying power will be restricted for 90 days or until the margin call is satisfied.
In addition to FINRA’s margin requirements, many brokers have their own house margin requirements. These requirements vary depending on the broker, but they are always more stringent than FINRA’s requirements.
Buying Power Limits
Pattern day traders may trade up to four times the excess maintenance margin in the account, as of the close of the previous business day, which is more than the 2-to-1 leverage available for overnight positions. The excess maintenance margin, or exchange surplus, is equal to the difference between the account equity and margin requirement.
Any trades exceeding the buying power limitation will trigger a margin call from the broker. At that point, the trader has the option to fund the account to meet the margin call, or the broker will sell securities to meet the required amount.
Different Rules for Different Markets
Pattern day trading rules only apply to U.S. equity markets. Futures, commodities and foreign exchange markets aren’t subject to the same strict regulations. Many day traders prefer these markets for that reason – especially if they don’t have more than $25,000 in risk capital.
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The Bottom Line
Traders should take the time to understand FINRA’s pattern day trading rules to avoid any costly problems. If you want to avoid these regulations, you can use a cash account instead of a margin account or trade in different markets, such as futures or currencies.