Many people who get into stock trading quickly start hearing about day trading as an easy way to make money fast. Just a few clicks and a few minutes of looking at stock charts and you can instantly be $1,000 richer (supposedly).
There’s only one thing stopping you: the pattern day trading rule. Long story short, this rule sets a minimum equity requirement on day trading accounts of $25,000 and a limit on the margin you can use in your trades.
That begs the question, if it’s so easy to make money, why is day trading restricted by the SEC? Is the SEC trying to stop people from making easy money?
If you’ve ever wondered those questions, here’s the answer: The restrictions prevent investors from taking on too much risk.
What is Day Trading
Day trading usually refers to the practice of buying and selling a security within a single trading day. The aim is to ride on intra-day price fluctuations for bigger profits than a buy-and-hold strategy. Get in before prices rise and get out before prices fall.
Day traders sit in front of computer screens and monitor stocks that have potential to move up or down in value. They want to ride the momentum of the stock and get out of the stock before it changes course. They do not know for certain how the stock will move, but they believe their research or analysis of price movements will give them a slight edge in predicting price movements than random guessing.
Most day traders trade on margin (money borrowed from brokers) to increase leverage and avoid settlement date violations that could happen in a cash account. If you don’t know what that is, don’t worry. All you need to know is that the margin requirements apply to most day traders.
Pattern Day Trading
Now that you know what day trading is, we can look at how it’s restricted.
The U.S. Securities and Exchange Commission (SEC) defines in FINRA Rule 4210 that a day trade is any trade that is opened and closed within the same trading day. Following that, they label accounts as pattern day traders when a margin account makes four or more day trades within five trading days and the number of day trades is more than 6% of the total trades taken in the five-day period.
If this occurs, the trader’s account will be flagged as a pattern day trader by their broker, and some restrictions will be applied to the account (see below).
Day trading applies to virtually all securities—stocks, bonds, ETFs, and even options (calls and puts).
Restrictions
The main restriction for pattern day traders is on the minimum account balance. In order to engage in pattern day trading, they must maintain an equity balance of at least $25,000 in a margin account. If that number drops below $25,000, the account will be prohibited from making any further day trades until the balance is brought back up.
A few notes about this restriction:
The required minimum must be in the account the day prior to any day trading activities. So if you were wondering if a balance hovering around $25,000 counts, only the closing balance of the previous trading day matters. This means if you want to daytrade tomorrow, you must have $25,000 in your account by the end of today.
When your account makes its fourth day trade in a five-day window, your account will be marked as a pattern day trading account for ninety calendar days. This means if you don’t have $25,000 in your account, you won’t be able to place any day trades for ninety days until you bring your account equity above $25,000.
The $25,000 equity balance restriction applies only to U.S. stock markets. The day trading restrictions on other markets vary.
The five-trading-day window usually operates on business days. This means that weekends don’t count towards those five days. A five-trading-day window could include Wednesday through Thursday.
Advantages
As stated in the beginning, the restrictions for day trading are in place to prevent investors from taking too much risk. To understand that, you need to know what are the advantages and disadvantages/risks that are unique to day trading.
The main advantage of day trading is that positions are usually closed at the end of each day, and are unaffected by huge, unexpected price movements overnight due to breaking news in the evening or off-hours broker moves. This means that you avoid so-called price gaps, a huge price movement from the previous closing price to the current opening price.
Disadvantages/Risks
All types of investments come with their inherent risks, but day trading is especially high risk. Here are some of the reasons why.
1. By its nature, day trading is more difficult compared to traditional buy and hold strategy. For long-term investment, you would usually buy a stock/fund, hold it for years before selling it, in order to avoid short-term market fluctuations.
On the other hand, day trading looks at short-term market moves. Day traders use numerous intraday strategies and complex algorithms, like scalping, range trading, news-based trading, high-frequency trading, etc. We won’t go into details of how they work, but just know that day trading requires an in-depth understanding of how the markets work and various strategies for profiting, even some luck and good timing.
2. Typically, day traders trade with leverage, which basically means borrowing money. This is because you need a lot of money to make the trading worthwhile. It’s also because some day trading strategies require using borrowed money to make profits. If you’re dealing with price changes of a few cents per hour, you will need a huge investment to make any worthwhile profit.
Borrowing money to trade in stocks is always a risky business. Without enough experience and knowledge, losses can be amplified, and you could lose all your money and end up in debt.
3. Compared to buying and holding, psychological bias can play a bigger role. Day traders have to watch market fluctuations closely and react promptly. It’s easy to get tunnel-vision and act under the effects of adrenaline and emotions. Common mistakes are selling winners too early or holding losers for too long.
4. Frequent trades can mean multiple commission costs. If your commission is $5 per trade, then you could easily hit the $100+ per month mark as a day trader. However, there are brokers such as Fidelity that allow you to day trade commission free for the most part.
5. There’s a lot of competition. With a well-planned strategy and extreme discipline, day trading can turn out to be a very lucrative career. That attracts many people who you will be competing with. Many of them are professional day traders. The pros are typically well-educated, have a lot of experience, have access to great research/analysis tools, have solid skills on technical analysis and chart reading, understand the market in-depth, and have developed the discipline for trading without emotions.
6. Day trading takes a good deal of time to learn. Putting in a few hours of research without consistently committing time to day trading won’t make someone a successful trader. It is highly unusual for day traders to produce income right when they get started (unless they just got lucky). Most day traders don’t see their efforts result in enough profits to pay themselves any type of income for many months
Success rate
Internet day trading scams have lured amateurs by promising enormous returns in a short period. It’s super common to see titles like “1 Trade, $1,253 Profits, 3 Minutes” (yup, that’s an actual title I found).
Unfortunately, the idea that this kind of trading is some kind of “get-rich-quick” scheme persists. Some people day trade without sufficient knowledge, and end up with big losses.
Although every day trader believes they can make money, the success rate of day trading is very low and most people who attempt day trading end up with net losses. Depending on who you ask, the numbers say 90% or more of day traders lose money over several years of trading. By the way, these are all people who likely thought they were “smarter” than everyone else.
Of course you will never see any of these people with consistent losses running a day trading blog or posting regular, high production value youtube videos on day trading. Because of this, it’s very easy to only see success stories on Youtube and on Google and start thinking day trading is easy money. Effectively, all eyes are on the top 1%, never on the 99% majority.
Conclusion
While day trading remains popular among inexperienced traders, it should be left primarily to those with the skills and resources needed to succeed. If you’re thinking about training yourself to reach that level of skill and discipline, it will take a huge investment of your time and money with no guaranteed return.
Don’t believe anyone telling you day trading is easy money. They’re probably just trying to sell you on their course containing their “secret day trading formula”.
Fun facts: I came up with the name PoketheJoe because I like poking him. I'm also smarter than Joe (but he doesn't think so).
- How Much Percent Of Your Portfolio Should Be International Stocks? - September 28, 2020
- Why is Day Trading Restricted - September 21, 2020
- How Long Do I Have To Wait To Buy A Stock After Selling It? - September 14, 2020