What Are the Rules for Day Trading?

Day trading involves the practice of frequently buying and selling securities within the same trading day, often with the goal of profiting from short-term price movements. Understanding the governing rules is important for anyone considering or engaging in day trading to avoid penalties, account restrictions, and ensure compliance with regulatory standards. This article will outline the key regulatory guidelines and requirements that govern day trading activities.

Understanding the Pattern Day Trader Rule

The Financial Industry Regulatory Authority (FINRA) defines a “day trade” as the purchase and sale, or the sale and purchase, of the same security on the same day within a margin account. This definition applies to any security, including options, and also covers selling short and purchasing to cover a position in the same security on the same day. Exceptions exist for long security positions held overnight and sold the next day before any new purchase of the same security, or short positions held overnight and purchased the next day before any new sale of the same security.

An individual is designated a “pattern day trader” (PDT) under FINRA Rule 4210 if they execute four or more day trades within five business days. The number of day trades must also represent more than 6% of the customer’s total trades in the margin account during that same five-business-day period.

Brokerage firms have automated systems to identify and flag accounts as pattern day traders. A firm may also designate a customer as a pattern day trader if it knows or has a reasonable basis to believe the customer will engage in such activity, for example, after providing day trading training. Once an account is coded as a pattern day trader, the designation often remains unless the customer contacts the firm to discuss a change in trading strategy.

Being designated a pattern day trader has immediate consequences, primarily the imposition of stricter financial requirements. These rules are designed to address the financial risk generated throughout the trading day, even if no security positions are held overnight. This designation helps ensure that brokerage firms have a cushion to meet any deficiencies in a customer’s account resulting from day trading.

Financial Requirements for Day Trading

Pattern day traders must maintain a minimum equity of $25,000 in their margin account on any day they engage in day trading. This required minimum equity can be a combination of cash and eligible securities. It must be present in the account before any day trading activities commence.

If the account’s equity falls below this $25,000 threshold, the pattern day trader will not be permitted to day trade. Trading restrictions will remain in place until the account is restored to the $25,000 minimum equity level.

Restoring the account involves depositing additional cash or eligible securities. If a pattern day trader exceeds their day-trading buying power, a day-trading margin call will be issued.

Failure to meet this day-trading margin call can lead to significant account restrictions. The account will be restricted to a reduced day-trading buying power, two times maintenance margin excess, until the call is met. If the call is not met by the deadline, five business days, the account may be further restricted to trading only on a cash available basis for 90 days or until the call is satisfied.

Using Margin in Day Trading

Margin in day trading involves borrowing funds from a broker to increase buying power beyond the cash available in the account. This leverage allows traders to control larger positions than their equity alone would permit. While it can amplify potential profits, it also significantly amplifies potential losses.

Pattern day traders have a “day trading buying power” of up to four times their maintenance margin excess as of the close of business on the previous day. This means that for every dollar above their maintenance margin, they can trade up to four dollars. This buying power is determined daily based on previous day’s closing equity values.

Maintenance margin requirements for day traders are designed to ensure sufficient capital is available to cover potential losses. Pattern day traders must meet the $25,000 minimum equity requirement. This higher requirement provides a cushion for the brokerage firm given the increased trading activity and associated risks.

Failing to meet a day-trading margin call by the deadline results in consequences. The account will be restricted to trading only on a cash available basis for 90 days, or until the call is met. Funds deposited to meet a day-trading margin call must remain in the account for two business days following the deposit. Brokerage firms may also liquidate positions in the account to cover the shortfall if the call is not met promptly, which can occur without prior notice.

Adhering to Trading Conduct Rules

Beyond specific day trading and margin rules, day traders must adhere to broader trading conduct regulations. One such rule is “free riding,” which prohibits the buying and immediately selling of securities without having sufficient cash in the account to pay for the initial purchase. This occurs in cash accounts when a security is purchased with unsettled funds and then sold before those funds have settled.

A “good faith violation” (GFV) is another compliance concern, arising when a security bought with unsettled funds is sold before those funds fully settle. Accumulating three good faith violations within a 12-month period can lead to a 90-day restriction on the account, limiting trading to only fully settled cash.

Day traders are also prohibited from engaging in market manipulation. This includes activities like “wash sales,” where a trader simultaneously buys and sells the same security to create a misleading appearance of trading activity without any change in beneficial ownership. Such actions are illegal and distort market perception. Similarly, “spoofing” involves placing large orders with the intent to cancel them before execution, aiming to manipulate prices or induce other traders to act. These activities are designed to deceive the market and are subject to penalties.

Regulatory bodies like FINRA and the U.S. Securities and Exchange Commission (SEC) play a role in overseeing trading conduct and enforcing these rules. These organizations work to protect investors and maintain market integrity, imposing sanctions for violations of trading conduct rules.