Day trading on margin – using borrowed money to manipulate one’s trading performance – is a risky investment activity. Margin trading is not for inexperienced traders, who have yet to develop appropriate approaches and procedures in risk management.
Trading margins work to improve profits and losses. Indeed, the main goal is to maximize trading income, but trading should also be viewed from a “defensive” viewpoint, since playing good defense is what will keep you in the game in the long run.
Day traders also execute several transactions a day to benefit from relatively minor fluctuations in the traded market. And if you’re going on a cold streak where the market is turning against you, leverage trading will wipe out a significant fraction of your trading account in the short run.
The sum you can borrow in your brokerage account for day traders is different for swing or position traders who have longer holding periods. Usually, day traders will borrow up to 4x the amount of cash they have deposited into their account bove the minimum threshold for equity requirement based on standard Regulation T (“Reg-T”) laws. It’s usually limited to 2x for those who hold positions overnight. Of course you’re going to want to consult with your broker and the laws within your jurisdiction. (More on this below.)
But the reason behind allowing day traders to borrow more heavily than long-term traders is that the smaller holding periods are less likely to lead to a material movement of the security. Hence, on any given place the predicted drawdown or possible loss is less. This includes the stipulation that positions will be shut down overnight. Any leverage above that required for overnight trading would result in your broker calling for a margin and automatic liquidation.
Pattern Day Traders vs Non-Pattern
Notice that the rules and regulations between the types of day traders can be very different. There are two primary differences. Some will be called “pattern day traders” while others will be deemed “non-pattern day traders.”
Pattern day traders are categorized as those performing four or more day trades within five business days, when one or more of the following are fulfilled:
(A) The number of day trades over the same five-day period is more than 6 percent of the overall margin account trades. Therefore, if a person conducts four days of trading within a week and conducts less than 67 other types of trading (to satisfy the 6 percent rule), he or she will be classified as a pattern day trader.
(B) The person undertakes two unmet day trade calls within 90 days (i.e., the buying power restriction is exceeded more than once within 90 days).
(C) The brokerage firm you trade with can also appoint you as a pattern day trader at its own discretion, if it has reason to believe that you should be listed as one. This can happen in situations where, for example, it provided you with day-trading training before an account in your name was opened.
On the official FINRA website you can find more FAQs about this issue.
If none of the above conditions are met then a trader will obtain a rating of a non-pattern day trader. In addition, if a pattern day trader does not conduct any day trades for 60 consecutive days, then his or her account will automatically be transferred to a non-pattern day trader account.
Why “Pattern” vs. “Non-Pattern” Matters
The solution lies in margin requirements. The margin criteria are considerably higher for pattern day traders. That is, pattern day traders have to set a higher minimum threshold for equity than non-pattern day traders.
Pattern day traders must have on their account at least $25,000 or 25 percent of the overall security market value, whichever is greater. In comparison, non-pattern day traders are usually provided with a minimum allowance of $2,000 in equity. If an account fall below its minimum requirement for equity, trading will be suspended before the stipulated sum is again fulfilled.
As mentioned above, pattern day traders can buy up to 4x the sum that exceeds the minimum equity requirement of $25,000.
For instance, if one has an account of $40,000 deposited, that amount is more than $15,000 ($40,000 – $25,000) above the requirement. By applying the 4x law, this implies that the account will transact securities worth up to $60,000 (i.e. $15,000 multiplied by 4).
If this amount is surpassed, the broker must issue a margin call with five business days to satisfy the call – for example, lowering the amount of securities held to a reasonable level. This is mostly achieved automatically by the broker, who would liquidate positions within an appropriate amount to get the account back on the desired level. If not, the day trading buying power would be limited to two times the maintenance margin excess in the intervening period – between issuing the demand and reaching it. If the trader fails to reach the margin call within the allotted five business days, cash-only trading is permitted. If the margin call is met this can be reversed.
Margin calls will be sent out as long as the buying power is infringed regardless of whether the positions were sold the same day. For instance, if a trader has $25,000 above his maintenance margin sum and wants to buy $110,000 from a specific stock (over the 4x stipulation), even though he purchases and sells that position within the same market hours, he may receive a marginal warning or call either immediately or the following business day.
Please note that these laws are not set down in stone, and may vary depending on the broker you deal with and/or the jurisdiction in which you trade in. Brokers also set down their own rules and have the freedom to alter and enforce their own laws to suit their own business interests. This can mean broadening the rules for what a pattern day trader is, imposing certain minimum criteria for equity or limiting the purchasing power of other accounts. Before signing up, you must always consult with your broker to see exactly what’s required and what particular rules may apply.
Having Realistic Expectations
Comprehending the risks is imperative if you want to day trade on the margins. Small price fluctuations of your owned securities can lead to outsized changes in your portfolio.
Using margin will allow you to trade with money that you currently don’t have and help with the undercapitalization issues that many traders have. This will of course not help you make more money, though, if you don’t have a viable trading plan or good risk management practices.
Trading isn’t a practical way to quickly become wealthy. Make a living off trading requires a fairly large capital base. With just a few thousand dollars no one would be able to make a living off trading. You need to start with how much income you need from trading and divide that by your projected percentage return per year to back up how much of a capital base you will need to make a living day trading.
For example, in nominal terms, the S&P 500 is projected to return around 7 percent a year in the future. Most hedge funds, which employ highly intelligent and knowledgeable investors, struggle to produce this annualized return. But this can be a practical target to achieve. Therefore, if you wanted $50,000 a year to reach your profit target, you would need a capital base of just over $700,000 ($50,000/0.07). And remember that markets don’t reliably yield you X percent annually. Depending on the approach and risk management there will be variations, even wild ones. There is no such thing as a secure return of 7 percent, and if you day trade you are likely to pursue volatile markets, such as equities, commodities and/or currencies.
Nonetheless, when properly used, margin can be a positive thing and help to drive one’s anticipated returns to a level of risk with which one is at ease. Margin trading can also be better than normal cash-only trading as it encourages a investor to follow a low- to moderate-risk strategy – understanding that leverage can help to maximize any profits are made – rather than a high-risk reward strategy, such as taking broad concentrated positions in high-risk securities.
Margin day trading can be dangerous, and starting traders should not seek it out. However, using small to moderate levels of leverage for seasoned traders with efficient trading strategies and structures in place can potentially be a less risky venture than using no leverage and chasing returns with suboptimal trading strategies.