Do You Need $25,000 To Day Trade?
Day trading has never been easier, thanks to the proliferation of investing apps and zero-commission brokerage firms that all but encourage active trading.
However, if the Financial Industry Regulatory Authority, or FINRA, deems you to be a “pattern day trader,” the same rules apply whether you’re paying for every trade through a traditional broker or executing no-commission trades on your own via an investing app or online firm. Specifically, if you’re labeled as a day trader, you must have at least $25,000 equity in your account before you begin any day trading activities.
Learn: 3 Things You Must Do When Your Savings Reach $50,000
Read on to learn more about this rule.
What Exactly Is a Pattern Day Trader?
It’s hard to observe a FINRA rule if you don’t know exactly who it applies to, or what exactly it means.
When you hear the term “pattern day trader,” you may think that it only applies to individuals or firms executing hundreds or even thousands of trades per day. The reality is that under FINRA’s quite broad rule, nearly anyone can be labeled a pattern day trader in today’s stock market environment.
Specifically, FINRA considers you a pattern day trader if you execute four or more day trades within five business days.
Day Trading by Definition
Opening and closing a position is considered one trade. To be categorized as a “day trade,” these opening and closing transactions have to occur on the same day to be counted. So, for example, if you buy Tesla in the morning at $188 and sell it in the afternoon at $195, that roundtrip trade is considered “one trade” for day trading purposes.
Under this definition, you can see how easy it might be to have your account labeled as a day trading account. If you buy and sell Tesla on Monday, buy and sell Amazon on Tuesday, buy and sell Microsoft on Wednesday and then buy and sell Tesla again on Thursday, you are considered a pattern day trader.
Day Trading and Short Selling
Remember that the pattern day trading designation applies to the opening and closing of positions, which doesn’t necessarily equate to buying and then selling.
If you’re a short seller, for instance, you will sell your shares first, then buy them back to close out that position. In this case, first selling and then buying back the same stock within the same day also qualifies as a day trade.
What Rule Applies to Pattern Day Traders?
If you exceed three roundtrip trades in one day within a five-business-day window, your account will get hit with the “pattern day trading” label. This means that your account will be restricted until you meet the minimum equity requirement of $25,000 in cash and/or securities.
What If You Don’t Have $25,000?
If you fail to meet the requirement, your account will remain on lockdown until you reach a five-day rolling period in which your total trade count is three or less. During this time, you won’t be allowed to close any of your open trades.
Remember that for the purposes of this rule, only round trip trades apply. For example, you can buy 100 different stocks every day of the week, and as long as you don’t close out those positions within the day-trading parameters listed above, you won’t have to worry about any restrictions.
What Is the Purpose for the Pattern Day Trading Rule?
Essentially, the pattern day trading rule was put into place to help protect smaller investors. As trading systems and the brokerage world evolved, individual investors gained access to placing their own trades — often commission-free — with rapid speed.
As overtrading generally leads to poor investment results — and as smaller investors tend to get wiped out with every market panic, from the 1987 crash to the dot-com bubble of 2000 to the financial crisis of 2008 — regulators decided to institute some level of protection.
The idea behind the $25,000 requirement for day traders was that only professional investors would have that type of capital to keep in a brokerage account, thereby preventing smaller investors from burning up their own accounts via day trading.
Of course, in this day and age, an account with $25,000 in equity isn’t that uncommon, even for “smaller” investors, so it’s questionable how much protection this rule still offers. However, at the very least it should serve as a signal to active traders that they should be sure they understand what they’re doing before they engage in pattern day trading.
What Is the Penalty for Violating the Pattern Day Trading Rule?
FINRA only requires accounts to be restricted until they clear the five-day window for excessive day trades. However, most brokers place more severe restrictions on accounts that engage in pattern day trading. Some brokers may restrict your account for 90 days, for example. If you continue to violate the pattern day trading rule, your firm may terminate your account.
Bear in mind that your account only violates the day trading rule if you have less than $25,000 in cash and/or securities in your account. If you can keep your account above this level, then no federal restrictions apply to how many trades you can make. It’s possible that your brokerage firm may have its own limits, however, so be sure to check with it before you engage in this type of trading.
How You Can Avoid the Pattern Day Trading Rule
If you’re an active trader, it can be quite easy to get snared by the “pattern day trading” rule of FINRA. But there are some easy ways to avoid it, as well.
Hold overnight: If you can hold your positions overnight, you won’t run afoul of the day trading regulations.
Use different accounts: The “four or more in five business days” rule only applies per account.
Keep your account balance above the requirement: If you keep your balance above $25,000 at all times, you’ll never risk violating the pattern day trading rule.
The Bottom Line
Regardless of how you manage your account, if you’re planning on day trading, be sure that you have a risk management strategy in place so that you don’t risk your entire portfolio.
This article originally appeared on GOBankingRates.com: Do You Need $25,000 To Day Trade?
