Oct 12, 2023
Written by:
Al Hill
Day trading refers to buying and selling any financial instrument, such as stocks, bonds, options, ETFs, etc., within the same day without holding the position open beyond the close of the trading day. This type of trading is also called intraday trading, and the traders doing it are called day traders. If you want to be a day trader, you need to know about the day trading rules created by the Financial Industry Regulatory Authority (FINRA) as your broker can restrict you from trading if you violate these rules. The day trading rules define who qualifies as a day trader and a pattern day trader. The rules also affect margin and minimum equity requirements for starting day trading. In this post, we'll give you all you need to know about the rules for day trading.
Pattern day trading
According to FINRA rules, a trader who performs four or more day trades within five trading days is considered a pattern day trader. However, the number of day trades performed during those five business days must be greater than six percent of the total number of trades executed in the margin account during the same period.
The rules for pattern day trading essentially mean that if you execute four or more day trades within five trading days, you must meet the minimum equity requirements and maintenance requirements before executing further trades. Often, this means your account is locked for 90 days, or you will have to apply for a forgiveness waiver with your broker.
Some brokers can place additional requirements on traders if they sense you are participating in pattern day trading. So, to be sure, you need to contact your broker to learn about the requirements of registering as a pattern day trader. The rules allow brokers to flag a trader as a pattern day trader if it “has a reasonable basis to believe'' that the trader would do pattern day trading.
Day trading rules under 25k
Pattern day-trading rules require traders to have an equity of at least $25k in their margin accounts on the day the trader executes a day trade. Cash and eligible securities both form part of the equity, which means that your account should have at least $25,000 worth of eligible securities or cash before executing a day trade. Your broker would restrict day-trading in your account if your equity falls below the $25,000 equity level threshold.
Pattern day traders can open trades worth up to four times their maintenance margin in excess of the previous day’s close. The maintenance margin excess is the surplus amount above the minimum maintenance margin. For example, if you have a maintenance margin excess amounting to $50,000, you can open trades worth $200,000.
Pattern day traders also have to follow margin call rules implemented by the SEC. For example, if a pattern day trader receives a margin call, they will have to answer it within five days and their trading ability would be reduced from four times to two times the trader’s maintenance margin excess until the margin call has been answered. If the margin call is not met even after five business days, the broker will have to restrict the trader’s account to cash account status for a period of 90 days.
What is a pattern day trader?
When you buy and sell a security within the same trading day, you have conducted a day trade. But you will be flagged as a pattern day trader if you make four or more day trades within five business days and the value of those day trades exceeds 6% of all the trades you executed in your margin account within those five days. In such a case, you must have at least $25,000 of equity in your account by the end of the trading day. Otherwise, the broker will restrict your account unless you have at least $25,000 worth of cash and/or eligible securities in your margin account.
As a pattern day trader, you will be subject to pattern day trading (PDT) rules, which include minimum equity, maintenance margin, and margin requirements, among other rules. However, pattern day traders often have access to leverage of 4:1, which allows them to trade four times the value they have in their margin accounts. This is in contrast to the standard 2:1 leverage that longer-term investors get. Your margin availability will depend upon your broker. Higher leverage means that pattern traders can open bigger trades than traditional longer-term traders and can amplify their returns on trades as well. However, leverage is a double-edged sword and can amplify losses as well.
Can you buy and sell stocks on the same day?
You can buy and sell stocks within the same day, which would be considered day trading. However, if you trade too frequently - four trades or more in five business days - and your day trades make up more than 6% of your total trades during those five days, you will be considered a pattern day trader. Once you are labeled as a pattern day trader, you’ll have to follow the FINRA pattern day trader rules (PDT) rules in order to buy and sell stocks on the same day.
One of the key rules of pattern day trading is that you must have at least $25,000 worth of equity before you put up your trade after you have been flagged as a pattern day trader. However, if you can’t afford to have $25,000 in your account, you should keep your day trades to a maximum of three trades per five business days. The $25,000 limit has been imposed by the SEC and FINRA to place a barrier and dissuade retail traders from taking too much risk.
What are the margin requirements for pattern day traders?
According to the SEC, the minimum equity requirement for a pattern day trader is $25,000, which is the amount that must be available in the customer’s account before executing any day trading activity. If the amount in the account drops below the minimum level of $25,000, the trading activity would be restricted until the amount is brought back to the $25,000 level.
A pattern day trader is allowed to trade up to four times their maintenance margin excess, which is calculated based on the previous day’s closing for equity securities. In case the trader exceeds this limit, the broker will issue a margin call for depositing the difference amount within five business days. During those five business days, the buying power is restricted to twice the maintenance margin excess in the trader’s account.
Day trading restrictions
FINRA’s definition of pattern day traders gives an impression that the rules are meant only for margin traders, exempting cash traders. The exemption might be true but cash-only traders can only reuse their cash after the proceeds from their previous trades are settled, which usually takes two days after the execution of trades (T+2).
For example, if you have $10,000 in your trading account and you buy and sell a stock within the same day and make a $2,000 profit, the proceeds from the trade would be settled after two days (T+2), before which you can’t use these funds. This renders cash-only traders exempted from day trading restrictions because the T+2 settlement prevents them from making frequent day trades.
How to day trade with less than $25,000?
If you have less than $25,000 in your account, you can still explore some options that will legally allow you to day trade. We've covered this in detail in a separate post, but here are the basics:
- You can only make three day trades within five trading days, which will enable you to stay within the legal limits without requiring you to have $25,000 in your account. The limited trades can be beneficial for you as it prevents you from overtrading.
- FINRA rules and minimum equity requirements for day trading apply only to the U.S stock markets, so you can consider trading foreign stock markets if you think you can excel in day trading. However, you should learn about the day trading rules of the country where you want to trade to avoid any inconvenience.
- You can consider adopting swing trading strategies, which require fewer trades as each trade typically lasts longer than a day. Alternatively, you can have a buy-and-hold strategy, which involves conducting fundamental analysis of a stock before buying it. The buy-and-hold strategy is for long-term investors who usually hold their positions for months and years to benefit not only from price appreciation but from dividends as well.
- You can open multiple accounts with different brokers and continue with up to three days every five trading days to stay within the allowable limits. For example, if you open an account with two different brokers, you can open up to six trades - three trades per account - within five days and still legally day trade without getting flagged as a pattern day trader. However, if you are undercapitalized, you won’t be able to make sizable trades to earn significant money.
- You can consider trading stock futures if you don’t have $25,000 with you. FINRA PDT rules don’t apply to futures trading, so you can easily trade as much as you like without breaking any of the pattern day trading rules. You also get high leverage, which allows you to open large positions by having just a fraction of the total value of trade in your account.
SEC day-trading rules
The pattern day trading (PDT) rules were put into force in 2001 by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) to put risk management measures in place for those who day-trade frequently. The dot-com stock bubble also encouraged regulators to impose more oversight on high-risk stock trading, and hence the SEC day trading rules were promulgated.
Day trading rules for futures
Pattern day trading rules do not apply to futures trading, so you can start trading without having the minimum equity of $25,000 in in your account. You can place as many trades as you like in a week without attracting pattern day trading restrictions. Traders can also open short trades in futures trading, unlike day trading, where short trades are difficult to open and are subject to various restrictions.
Day trading rules for options
Options are financial contracts that give the option holder the right, but not an obligation, to buy or sell a specific security at a certain price on or before a specific date. The pattern day trading rules also apply to the trading of equity options.
Similar to trading equities, you must maintain a balance of $25k in your brokerage account in order to play more than three options day trades in a five-day period. Otherwise, you will be flagged as though you were buying or selling the same day with simple equities purchases.
What happens if you violate pattern day trading rules?
It depends on your broker as to how it deals with your first-time PDT rules violation. If your broker has a lax policy for first-time offenders, the most it would do is to flag you as a pattern day trader in the sense of a violator and will monitor your trading activities for consistent offenses. So, you should tread carefully and stay within the allowable limits.
If your brokerage isn’t forgiving on your first violation, it may give you a minimum equity call, which means that you’ll have to deposit the minimum equity requirements of $25,000 stipulated in the PDT rules for pattern day traders. Even if you don’t want to day trade in the future, you still have to fulfill the broker’s call of minimum equity requirements as set out in the rules. You can be restricted from opening new trades if you make an additional day trade despite being flagged as a pattern day trader.
If you don't want to day-trade but you mistakenly or unknowingly broke the pattern day trading rules due to which your broker flagged you as a pattern day trader, you should contact your broker for your options. Your broker might give you some alternatives that might allow you to continue trading. The rules regarding pattern day trading are strict, and your broker might have limited options to remove PDT flags. You can enter into some agreement with your broker for one-time PDT flag removal, but it might be next to impossible to remove it after continuous rules violations.
How can you do day trading legally?
If you want to day trade legally without breaking PDT rules, you need to apply for a margin account. It would give you buying power equal to four times the balance in your account. You can inform your broker beforehand when filling out your account opening form that you would be day trading in your account. However, you will need to deposit $25,000 equity in your trading account to continue day trading without any hindrance.
There are ways around this rule, like having an international broker, or trading futures. We discuss these options in our tutorial on how to day trade without $25k.
It also goes without saying that if you are new to day trading, you should begin in a simulator. You can day trade legally here at TradingSim with over 3 years of historical, accurate, and realistic market replay. Be sure to test your day trading strategies here before you jump in the deep end.
Tags: Day Trading Rules
