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You Should Know These Day Trading Rules

Updated on 2012-10-19 by Guest

Day trading has its own inherent potential for risk and reward; thus, it is subject to specific restrictions and requirements. Here, in this article, we cover the day trading rules all aspiring day traders should know beforehand.

Day Trading Defined

Day trading is the buying and selling of stocks all within one trading day to take advantage of price fluctuation in an attempt to make a profit. If a trader executes 4 or more round-trip trades within 5 consecutive business days, he is labeled as a pattern day trader.

It is important to keep in mind that even occasional day traders can be labeled as a pattern day trader the moment he meets the criteria explained above. The moment a day trader makes 4 round-trip trades, the brokerage firm will consider the customer as pattern day trader without needing to wait for 5 business days.

How to Count Number of Round-trip Trades?

If you are aspiring to become a day trader or you’re already trading occasionally, you need to know how a trade is counted. Sometimes this poses some confusion to traders. As per FINRA rule, a round-trip trade is the lesser number of transactions in opening or closing a position.

Say for example, you bought 500 shares of ABCD stock. Then you sold the stock with two 250-share orders. Based on the rule, it will still be counted as one trade. If you entered a position in two 250-share orders and closed all your position in one execution; it will be considered one trade.

But say for example, you opened position with two 250 share orders and closed the position in two 250 share orders; it will result in two day trades even if a similar 500-shares position is created.

Another example that confuses some traders is the case of partial fill. Say for example, you made an order to buy 500 shares of ABCD stock; then the order is partially filled with 200; then 100; and another 200. It is still considered as one trade provided that you didn’t modify the remaining balance 300 shares after the initial fill. If you made some modifications to the remaining share balance, it will be considered a new trade.

Pattern Day Trading Rules

If you made 4 or more trades in 5 consecutive business days, you are subject to the following rules:

Minimum Equity - you have to have at least $25,000 worth of equity in your account. If you can maintain this minimum equity, you can day trade as frequently as you want. Equity refers to the money available once every position in the account is closed.

Margin Call – Once the account’s equity falls below the $25,000 minimum requirement, a margin call request is made. You have to restore the account’s equity by making cash deposits. You have 5 business days to meet margin calls. If you’re not able to deposit funds, your account will be frozen for 90 days or until the margin call is met.

Rules on Leverage

One advantage that pattern day traders have over occasional day traders is the increased leverage. Non-pattern day traders with margin accounts can hold positions with value up to twice the amount of money in their account. For example, you are a non-pattern day trader and you have $30,000 in your margin account; you can hold positions of up to $60,000 in value.

If you are a pattern day trader, however, the leverage is up to 4 times the cash on your margin account. So in the same example above, you can hold positions of up to $120,000 in value.

Caveat on Leverage

There is a caveat to leverage benefit if you’re a pattern day trader but wish to hold positions overnight. You have to reduce your positions to twice the amount of cash you have in your account. So in the example given above, your $120,000 holdings must be reduced to $60,000 to hold your positions overnight.

There’s no restriction on non-pattern day traders standard margin accounts. In the example, they can hold the maximum of $60,000 overnight if they want to.

While margin trading is one of the best advantages in being a pattern day trader, it can pose risks too. Think of it as a double-edged sword – it’s a tool that can go in your favor, or it can go against you. You get to magnify your profit - or lose more than your capital. That’s why although trading on margin is beneficial, there’s no guarantee that it is profitable. It all still depends on the trader’s skill.

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Trading financial instruments, including foreign exchange on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in financial instruments or foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading and seek advice from an independent financial advisor if you have any doubts.