Pattern Day Trading
If the investor regularly buys and sells stocks on the same day, they may be designated as a pattern day trader by their investment firm. A pattern day trader is someone who executes four or more day trades within five days, representing more than 6% of their total trades. Financial firms are required to designate investors as pattern day traders if they fit this definition or if the firm has a reasonable basis to believe that they will engage in pattern day trading. Those designated as pattern day traders are required by Financial Industry Regulatory Authority (FINRA) rules to maintain a minimum balance of $25,000 in a margin account. Day trading in a cash account is almost always prohibited.
Example of Day Trading
Sally is an investor with a brokerage account and she trades stocks based on news headlines. Sally makes the following trades on the following days of the week: Since Sally executed four day trades within five days or less, representing more than 6% of her trades, Sally is considered a pattern day trader. Because of this designation, her brokerage requires her to maintain at least a $25,000 balance in a margin account at all times.
Bought 25 shares of ABC Computers, then sold all 25 sharesBought 50 shares of XYZ Holdings, then sold all 50 shares
Bought 100 shares of 123 Media and later that day sold them
Bought 50 shares of ABC Computers, then sold them all before the end of the dayBought 50 shares of XYZ Holdings, then sold them all before the end of the dayBought 50 shares of 123 Media, then sold them all before the end of the day
However, had Sally just made one buy and one sell of each company on each day in the above example, she would not be considered a pattern day trader, according to FINRA’s rules. Someone may be day trading a security but not be considered a pattern day trader if the trade volume does not exceed FINRA’s pattern day trader requirements.
Day Trading in Other Markets
Stocks are not the only asset you can day trade in. Day traders also operate in the foreign exchange market (also known as the forex market) and in the futures markets where mostly commodities are traded. Each of these markets works differently and has their own rules. Minimum balance requirements for day trading forex will depend on the broker that maintains your account. As a result, investors can place as many buy and sell trades as they want in a foreign-exchange investment account. Different markets also keep different hours. For example, stocks trade between 9:30 a.m. and 4 p.m. between Monday and Friday in the U.S., while futures and forex markets trade almost 24 hours a day for at least five days in a week.
Types of Day-Trading Strategies
There are many different strategies investors can implement when day trading. Some strategies focus more on technical indicators, some on news and media, and others use algorithms to buy and sell securities. Some common types of day trading include:
Momentum trading: This is buying and selling securities based on the strength of current price trends. Momentum is often determined by volume, volatility, and time frame.High-frequency trading: This uses software and algorithms to buy and sell securities within short time frames, taking advantage of small price changes for a profit.News-based trading: This type of trading makes day trades based on news reports and press releases of the underlying securities.
Some day traders stick to one strategy, and others use multiple strategies to make trading decisions. Remember that your investment bank may also provide tools and access to exclusive reports to aid your efforts in making timely day-trade decisions.
Pros and Cons of Day Trading
Pros Explained
Potential for quick, large profits: Day traders can have multiple profitable trades per day, often leveraged with margin accounts for even larger returns.No overnight holding risks: Because day trading is defined as buying and selling a security within the same day, all positions are closed out by the end of the trading day, which means no risks holding positions overnight, such as after-hours news updates that negatively impact your holdings, for example.Compounding profits: Each profitable trade increases your buying power for the next trade, compounding with each profitable transaction.
Cons Explained
Comes with considerable risks: Perhaps the most significant risk associated with day trading is the potential for large losses. Day traders often leverage their positions, which means they could potentially lose more than they initially invested. Can be very time-consuming: It may take a lot of time reading chart patterns, momentum indicators, news headlines, etc., in order to find the right trade. It may take hours per day to see significant profits since most profitable trades are incremental and small in relation to your account balance. High balance requirements: Being a pattern day trader requires that you maintain at least $25,000 in a margin account. Taxes: Buying and selling stocks for a profit within a short time can lead to tax implications. Profits from day trading could incur short-term capital gains tax, which is taxed as ordinary income.
Day Trading vs. Investing
Investors with large balances and extra time to day trade can make incremental, compounding profits when they follow general day-trading strategies. In any case, remember that day trading comes with significant risks and the potential for larger-than-normal losses.
