The purpose of this article is to provide an overall background on some of the key rules related to day trading violations, and how to avoid potential violations of those rules. Day trading, simply put, is taking advantage of the day-to-day moves in the overall stock market or on an individual stock or other asset (e.g., options contracts). This type of trading is very different from traditional investing, which involves purchasing stocks, bonds and other investment assets over long periods of time. An investor’s level of risk tolerance usually dictates their desire to become a day trader versus a passive long-term investor.
Day trading has become much more common, with the advent of home offices, cheaper and more powerful computers, and fast internet connections. Add these factors with the rise of online stockbrokers and low cost or free trades, day trading has become a viable way for individual retail investors to conduct same day trades.
Day Traders Use Online Investment Brokerage Services
To legally day trade stocks in the United States, a day trader must use the services of an online investment broker. The investment brokers require you to maintain a daily account balance, called a “margin.” A margin account is generally defined as a brokerage account in which a broker lends the customer cash to purchase stocks or other products. The loan in the margin account is collateralized by the products purchased (e.g., stocks, options, etc.).
There will be further discussion below about margin accounts, including a discussion on pattern day trading rules that will help you avoid day trading violations.
The top online brokerage firms provide speed, reliability, and low costs for trades. In addition to these services, quality brokerage firms also provide trading platforms that offer the day trader the ability to practice day trades using “paper money,” which is essentially fake money.
The key, however, is that in order to properly conduct day trades on a consistent basis, most successful day traders use a top-of-the-line online investment brokerage firm. Using a top broker generally helps the day trader stay in compliance with general day trading rules, as these brokerage firms have alerts and other notifications already established internally in their trading software programs, which helps alert the user to improper trades or actions.
Day Trading Violations: What Is a Pattern Day Trader?
If you are considering day trading as a career, or part time activity, an important concept to understand is the term “pattern day trader.” According to the Financial Industry Regulatory Authority (FINRA), a person is considered a pattern day trader if he or she executes four or more day trades within five business days. This is provided that the number of day trades represents more than six percent of the day traders’ total trades in the margin account for that same five business day period.
The rule regarding four or more trades within five business days is a minimum requirement. In other words, some online investment brokers use a varied definitions to assess whether any one customer qualifies as a pattern day trader.
Those who day trade needs to review and understand their own brokerage account firm’s rules and guidelines to determine whether their trading activities will define them as a pattern day trader.
An investment broker may determine that a customer is a pattern day trader if the firm “knows or has a reasonable basis to believe” that a customer will engage in pattern day trading. For example, if a customer’s investment broker provided day trading training to such customer before opening the account, the firm may simply designate that customer as a “pattern day trader.”
Finally, it is important to note that, once a day trading account has been defined as a pattern day trading account, many brokerage firms will continue to define that account as a pattern day trading account, even if that trader begins to trade much less. This is because the firm will have a “reasonable belief” that the customer is a pattern day trader based on past account activities.
In sum, it is important for a more active trader to review their brokerage account rules regarding what is pattern day trading, so that person can know whether he or she will be labeled as a pattern day trader.
Day Trading Violations: Rules for a Pattern Day Trader
Once it is determined that you are a pattern day trader, you will need to be aware of the rules associated with such an account.
In general, trading regulations published by the U.S. Securities and Exchange Commission state that all traders who trade four or more times in five days must keep $25,000 in their margin accounts to conduct trades.
In addition to the $25,000 minimum, a trader will also need to meet the “maintenance margin requirement.” Per FINRA rules, the current maintenance margin requirement is twenty five percent, meaning after any purchase, the trader must maintain 25% equity in his or her account. By way of example, if the total value of securities in your account were $100,000, and you had a $20,000 margin loan balance, your equity would be $80,000, or 80%. In this example, the trader would be operating within FINRA rules.
If that percentage of equity were to fall below twenty five percent, the trader’s brokerage firm could issue the trader a margin call. This requires the trader to fund his or her account with cash or securities to bring the equity in the account to the twenty five percent requirement.
What Is a Cash Account
You are able to day trade without a margin account. The most common way to not be labeled as a pattern day trader and avoid day trading violations (and be subject to the rules of a PDT), is to start your trading by opening a “cash account.”
Unlike a margin account, a cash account allows you to purchase securities with the cash in your account. For example, if the trader deposits $7,500, he or she can then purchase up to $7,500 in securities. If that trader wants to buy more, he or she would then have to deposit additional funds in the cash account (or sell other investments).
Importantly, with a cash account, the trader’s potential losses are always capped to the amount invested. Using the same example, if the trader invests $7,5000 in a stock, the most money that can be lost is $7,500. This is the main reason why cash accounts are a smarter option for new and inexperienced investors.
Summary: Day Trading Violations
In sum, learning how to become a day trader is a potentially good way to earn money in the stock market. In order to begin, however, it is important to know the rules of day trading in order to avoid day trading violations, including what rules your brokerage firm applies to your trading activities.
You will need to understand what capital will be necessary to meet the guidelines and restrictions of the type of trading (time and amount of money) that you want to conduct.
The best way to educate yourself is to identify a brokerage firm that you want to use for day trading, and then learn the rules that the firm follows for various trading accounts (e.g., margin account and cash accounts, among others). Also, it is always helpful to simply call the firm’s customer service line and ask questions about your account, including topics like the company’s pattern day trader rule, a pattern day trading flag, what is a minimum equity call, minimum equity requirements, and other similar issues.
In addition, conducting extra research with online resources is beneficial to understand rules applicable to your trading style and account, especially before making an initial purchase of stock or options.
Learn More
Maurice Kenny has helped over 600 people become financially free through one-on-one coaching, mentorship, and options trading strategy. Many of these new traders are now full-time traders, and they all started by watching his 1-hr webinar.
Feel free to check out other FREE educational resources to help guide you as you begin your new journey to financial freedom.
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