You've set up a brokerage account to trade stocks. Now you wonder how anyone is going to know whether you're a bona fide "day trader."
Your broker will know, based on your trading activity. The Financial Industry Regulatory Authority (FINRA) in the U.S. set the "pattern day trader" rule, which states that you're a pattern day trader if you make four or more day trades in a five-day period in your margin account, and those trades are more than 6% of your total margin trading activity during that time. (Day trading is opening and closing a position within the same day.)
If you're a pattern day trader, you must maintain an account balance of at least $25,000.
Background on Day Trading Equity Requirement
Back in 1974, before electronic trading, the minimum equity requirement was only $2,000. New technology changed that. The faster speeds allowed traders to get in and out of trades within the same day.
Since day traders might hold no positions at the end of each day, they have no collateral in their margin account to cover risk and satisfy a margin call during a given trading day. Brokerage firms wanted an effective cushion against margin calls. This led to the increased equity requirement.
Perhaps you don't usually day trade but happen to do four or more such trades in one week, with no day trades the next or the following week. In that case, your brokerage firm would still likely classify you as a pattern day trader. It would hold you to the $25,000 equity requirement going forward.
You can meet the requirement with a combination of cash and securities. However, they must reside in your day trading account at your brokerage firm rather than in an outside bank or at another firm.
If you're a pattern day trader and you do not have $25,000 in your brokerage account prior to any day trading, you will not be permitted to day trade. The money must be in your account before you execute any day trades.
On the plus side, pattern day traders who meet the equity requirement receive some benefits, such as the ability to trade with additional leverage—using borrowed money to make larger bets. A stock day trader can trade with 4:1 leverage, while typical stock investors (including swing traders and those who tend to buy and hold) can trade with a maximum of 2:1 leverage.
Day Trading Loopholes
If you don't happen to have $25,000 to day trade, there are ways to get around that requirement. They consist of loopholes and alternative trading strategies, most of which are less than ideal.
- Make only three day trades in a five-day period. That's fewer than one day trade per day, which is fewer than the pattern day trader rule set by FINRA requires. However, this means you'll need to pick and choose among valid trade signals. You won't receive the full benefit of a proven strategy.
- Day trade in a stock market outside the U.S. You'll have to do this with a broker that's also outside the U.S. Not all foreign stock markets have the same account minimums or day trading rules as the U.S. Research other markets and see whether they offer day trading that fits your needs. Consult both tax and legal professionals before taking this approach.
- Join up with a day trader firm. The structure of each firm varies, but typically you deposit much less than $25,000. It provides you with additional capital to trade, with your deposit safeguarding it from losses you may take. Otherwise, the firm simply leverages your capital.
- Do swing trading and enter trades that you hold for longer than one day. Swing traders capture trends that play out over days or weeks rather than attempt to time a one-day trend that might last for 20 minutes. This is less a loophole and more of a change in strategy, but it works for traders who want to stay involved but don't yet meet the $25,000 requirement for day trading.
- Open day trading accounts with different brokers. This is a less-attractive choice. However, if you open two accounts, you can make six day trades in a five-day period—three trades for each broker. That isn't the best solution. If you already have limited capital, each account is likely to be quite small. Day trading with such small accounts isn't likely to produce much income. With small amounts in each account, you are limited in the stocks you can trade. Some brokers may not even accept the small deposit.
Brokers are out to protect themselves. They can impose minimum capital restrictions if they believe someone is day trading regularly (even if below the four-trade/five-day threshold) or trading in a risky manner.
Day Trading in Different Markets
On option that is better than taking advantage of a loophole or adopting a different trading strategy is to change markets.
The forex or currencies market trades 24 hours per day during the week. Currencies trade as pairs, such as the U.S. dollar/Japanese yen (USD/JPY). With forex trading, consider starting with at least $500, but preferably more. The forex market offers leverage of perhaps 50:1 (though this varies by broker). So, a $500 deposit means you can trade and earn—or lose—off of $25,000 of capital. Profits and losses can mount quickly.
The futures market is where you can trade stock index futures (the E-mini S&P 500, for example) and commodities (such as gold, oil, and copper). Futures are an inherently leveraged product. A small amount of capital, such as $400 or $500 in the case of the E-mini contract, gives you a position in a product that typically moves 10 or more points a day, where each point is worth $50.
Profits and losses can pile up fast. It's recommended that futures traders start with at least $2,500 (if trading a contract like the E-mini), but that will vary based on risk tolerance and the contract(s) traded.
Almost all day traders are better off using their capital in the forex or futures market. These markets require far less capital to get started, and even a few thousand dollars can start producing a decent income.
Day trading the options market is another alternative. An option is a derivative of an underlying asset, such as a stock, so you don't need to pay the upfront cost of the asset. Instead, you pay (or receive) a premium for participating in the price movements of the underlying asset. The value of the option contract you hold changes over time as the price of the underlying asset fluctuates. What type of options you trade will determine the capital you need, but several thousand dollars can get you started.
The Bottom Line
While pattern day trading requires a large amount of equity, there are loopholes and other investment options that may require you to put less of your money on the line. Before investing any money, always consider your risk tolerance, and research all of your options.
Frequently Asked Questions (FAQs)
How do you pick stocks for day trading?
Day traders don't typically concern themselves with business fundamentals like profitability or growth. Instead, day traders seek out volatile stocks that are likely to experience significant price changes in short timeframes. Day traders also look for technical chart patterns that offer some statistical likelihood about upcoming price movements. Stock screeners can help find these opportunities.
Is it a day trade if I place four limit buy orders in a day?
You can buy as much as you'd like without using one of your three non-pattern day trades for the week. Those buys would only become day trades if they are sold by the end of the day. Each sell order would create a day trade, so you could buy four times in the morning and place one sell order in the afternoon for a daily total of one day trade.
Why don't day trading rules apply to futures?
The futures market is an entirely different market than the stock market; they trade on different exchanges and the bulk of the regulation is done by different authorities. The futures market is largely regulated by the National Futures Association and the Commodities Futures Trading Commission, and these organizations do not have the same requirements as FINRA.