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Last updated on August 9th, 2022 at 09:44 pm
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There are a lot of common misconceptions floating around regarding day trading. Many new traders wonder if it’s legal, what the rules are, and whether they should try it.
If you’re curious about any of those topics, we’ve got you covered.
Day trading is legal, but it is also risky, and brokers have many stipulations regarding it. Because of this, you should only day trade if you’re an experienced investor who has thoroughly researched the rules and risks.
Additionally, you should consider whether day trading fits your investing style and even your stress levels.
Below, I compiled everything you should know regarding the rules of day trading. This article also shares some of the factors to consider before you try it for yourself. So, let’s dive in!
Know The Rules Of Day Trading
According to the SEC, day trading is neither illegal nor unethical.
However, it’s a pretty risky practice that requires some experience and capital if you want to hit the ground running.
And even though it’s legal, that doesn’t mean there aren’t rules. FINRA enforces various regulations regarding day trading.
You’ll need at least $25,000 to regularly day trade if you have a margin account. But brokers may choose to require an even higher amount.
If you have a cash account there is no required minimum amount to be able to day trade.
In addition, specific other stipulations apply to you once FINRA or your broker classifies you as a pattern day trader.
Pattern Day Trading
So what is a pattern day trader, and how do you become one?
Pattern day traders are essentially people that FINRA (and brokers) classify as regular day traders.
As a result, they’re subject to particular rules and exceptions.
According to FINRA, there are two ways someone becomes classified as a pattern day trader:
- They day trade 4 or more times within 5 days. However, those trades must equal over 6% of that person’s entire trading activity within that period.
- Their broker or investing firm reasonably classifies that person as a pattern day trader based on their trading behavior.
Pattern Day Trader Rules & Exceptions
Once labeled a pattern day trader, you must observe a minimum equity requirement of at least $25,000 if you have a margin account. If you dip below that amount while day trading, your account will be subject to restrictions.
Keep in mind $25,000 is just what FINRA enforces as a minimum. Your broker may have a higher required account balance for day trading, which means that you’ll need even more capital to meet their equity call and continue day trading through them.
These rules mainly exist to protect firms and brokers taking on the risks of their clients’ day trading.
The $25,000 minimum acts as a cushion for the credit they extend on those margin accounts.
Being a pattern day trader does come with some benefits, though – chief among them, increased leverage.
Day traders are permitted up to 4:1 leverage. Conversely, traders holding their positions overnight are only allowed 2:1 leverage.
Being labeled a pattern day trader doesn’t matter if you have a cash brokerage account. With a cash account you can’t use leverage but you also don’t have to worry about the $25,000 minimum account balance.
Should You Day Trade?
So, time for the golden question: should you try your hand at day trading?
Whether you should day trade will differ from person to person. Day trading is risky and requires preparation. So before you dive into it, consider your experience level, the taxes on day trades, and your individual investing goals.
Let’s look at how each of these points might apply to you.
By the end, you’ll have a better idea of whether or not you want to try your hand at this potentially lucrative market tactic.
Consider Your Experience Level
For years, many considered day trading as something only wealthy Wall Street pros could execute effectively. However, in recent years, market-savvy millennial retail investors have brought day trading into the mainstream.
But even though it’s more popular, day trading is no less risky.
It requires a firm grasp of the various regulations that surround the practice. Otherwise, prospective day traders may find themselves in violation of rules that they didn’t know existed.
It’s also one of the most involved forms of trading. You have to keep a close eye on market movements and strike when the anvil is hot.
Taxes on Day Trades
One thing new investors may not realize is that day trades can be taxed differently.
All your profitable stock market trades are subject to either a long-term or short-term capital gains tax.
Long-term capital gains tax is the more preferable of the two since it will cost you significantly less. It applies to investments you hold for more than a year.
Short-term capital gains taxes are heftier, matching the rate you pay on your normal income. They apply to anything you profit off of after holding for less than a year.
Since day trades are inherently short-term, they’ll always incur the higher short-term capital gains tax rate.
Your Investing Goals
Whether or not you should day trade depends largely on your trading strategy.
Day trading is considered one of the most aggressive and active forms of investing. It demands constant attention and quick thinking in many situations.
If you prefer to sit back and passively invest, then day trading isn’t for you. In fact, it’s not really investing at all since day traders buy and sell their securities within a day.
It’s more akin to gambling in many respects.
Similarly, you shouldn’t try it if you don’t possess a strong risk tolerance.
If you day trade, you’ll regularly see your portfolio and assets swing dramatically in value. And the potential for huge losses will loom ever-present.
Consequences of Breaking Day Trading Rules
Day trading is entirely legal. But that doesn’t mean there’s no punishment for breaking the rules.
FINRA and your brokers won’t press charges against you for day trading. But they can do other things to restrict your account and funds.
Once they label you a pattern day trader for the first time, your broker will enforce a minimum equity call. If you don’t meet the $25,000 required by FINRA, your broker will restrict you from making further day trades (again this is only if you have a margin account).
Your account will remain unable to day trade until you meet that minimum equity requirement.
Also, you can be margin-called if you exceed your buying power limitations while day trading.
But thankfully, pattern day traders get a bit of a break in this respect with their increased leverage.
Day trading is an exciting and lucrative way to make money. But it can also ruin the portfolios of many investors who jump in before doing their research.
Before you try it for yourself, make sure you understand the rules and meet all the requirements.