Complete Guide to Day Trading Rules

Are you the type of person who loves risk and isn’t intimidated by a steep learning curve – especially if there’s a possibility of gains on the other end?

If so, day trading could be a good fit for you—provided you have the time for this intensive trading method.

Day trading has the potential to be profitable, but this strategy comes with a lot of hidden risks. As in any type of investment opportunity, traders can always lose the invested funds, and in the case of leveraged trading, a trader can even end up owing money. 💸

Many novice traders who dabble in day trading lose money—in fact, most day traders on Robinhood do. So, before you decide to go all in on this strategy, make sure you fully understand what you’re signing up for.

There are also a number of rules and regulations associated with day trading. The stakes are high, as breaking these rules can come with severe penalties and day traders can also end up with a big tax bill from the IRS.

This guide covers the most important aspects of day trading, focusing on what it takes to become a day trader – including knowing and following the rules in order to avoid getting in trouble with your broker.

Let’s get into it 🚀

What is Day Trading? ☀

Day trading involves making a lot of small trades throughout the course of a single day. Stock prices, especially the prices of derivatives, tend to be rather volatile, and if a trader makes small, quick investments, they can garner profits from morning to the end of the business day.

Opening and closing positions during market hours allows traders to avoid exposure to overnight risks. If news comes out after the market closes, it can sway the price of the security in either direction. Instead, day trading tries to capitalize on small price fluctuations that happen within one trading day.

Day trading mostly happens with leveraged funds and can even be forbidden in cash accounts in some brokerage firms or exchanges. While leverage does have its upsides, like the return on investment being multiplied, it poses risks as well. The largest risk is that a trader can lose more than their deposit if the financial instrument they’ve invested in moves in the wrong direction too much.

Overall, day trading is about taking on risk to realize larger profits over a smaller time frame. If you’re new to it, consider exploring the best day trading courses to build a solid foundation. It also requires a lot of dedication as traders need to keep following both company news and market prices throughout the day, each day. If a trader knows how to do it right and have the funds to afford the risk, it could become their day job.

Although the gains day traders are looking for are sometimes less than a dollar in stock value, the profits can be multiplied by using leveraged funds or various forms of derivatives trading. Multiple successful trades per day can create a sizable income.

However, a few positions closed within a day do not make one a day trader. So, what does?

When Do You Become a Pattern Day Trader? 🗓

As per the Financial Industry Regulation Authority (FINRA), a pattern day trader is a person who closes more than four positions over the course of a single day within a five-day timeframe. When an investor does that, their brokerage firm will flag them as a pattern day trader and the investor will be asked to comply with the firm’s regulations. There are a number of important rules that pattern day traders must follow.

Pattern day traders are required to maintain a minimum equity of $25,000 in their margin accounts on any day they choose to trade. This $25,000 can be a combination of cash and other assets deemed eligible by the brokerage firm.

Brokerages go to these lengths to regulate pattern day traders because day trading is considered risky. This is because they want to ensure that they have sufficient funds to cover a trader’s losses in the event a sudden change in the market works against them.

So, if someone is interested in becoming a day trader, they need to make sure they have $25,000 in equity to satisfy FINRA’s minimum account balance requirement. They also need to ensure they can withstand the risk of losing $25,000 or more. 

Day Trading Terminology 📚

Now that we’ve discussed some of the basic rules, let’s look at the terminology of day trading before we take a closer look at day trading rules and strategies.

Swing Trading ☑

A short-term trading strategy that involves holding a position overnight, sometimes over the course of several days. Swing trading can be similar to day trading but carries a different set of risks and benefits, primarily that it does not set off the day trading counter with one’s broker.

Stock Market Hours ☑

The time during which the market is open, and the timeframe for day trading. NYSE market is open from 9:30 AM to 4 PM EST, Monday – Friday. The market is closed for nine federal holidays in the year 2022. Foreign markets will vary in terms of operational hours.

Cash Account ☑

A cash account allows traders to use the exact amount they’ve deposited to trade on the market. These accounts are typically used to invest in stock and bonds, for the long term.

Margin Account ☑

A margin account allows traders to use borrowed funds to exercise their trades. This makes it possible to control a lot more assets with smaller cash investments and allows for faster trades. While there are clearly numerous advantages, margin trading comes with significant risks. It should only be used by experienced traders.

Trading on margin entails the use of leveraged funds to trade. Such leveraged funds are borrowed from the brokerage firm. This allows an investor to use a relatively small upfront deposit, to control a larger sum of money provided by the firm.

Entry Point ☑

The price at which a trader acquires the asset. If a trader purchases Coca-Cola (KO) stock at $59 per share, then “$59” is the entry point.

Exit Point ☑

The price at which a trader sells the asset at a profit or to close a losing position. If a trader sells KO stock at $61 per share, then “$61” is the exit point.

Market Order ☑

As the SEC puts it, a market order is an order to buy or sell securities instantly. However, the exact price cannot be guaranteed—the market order will be executed at or near the price at the time of giving the order. So, a market order guarantees that securities will be bought, but it cannot guarantee the exact price.

Limit Order ☑

A limit order is an order to purchase or sell a security at a specific price. For instance, if a trader wants to buy TSLA stock at $850, but TSLA is currently trading at $925, then a limit order would not execute until TSLA reaches $850 or lower. This is called a buy limit order, while the opposite—establishing the lowest price a trader wants to sell the asset for—is a sell limit order.

Day Trading Strategies 📜

Now that you know a little bit more about day trading, let’s dive into a few popular day trading strategies. The strategy employed by traders plays a big role in the trader’s chances of being flagged as a pattern day trader and can come with numerous day trading rules.

Scalping 🛠

This strategy is geared towards making a profit from small changes in a stock’s price. The process of scalping stocks involves a trader placing anywhere from ten to several hundreds of trades in a single day, focusing on catching the smaller moves in a security’s price.

Let’s say Bill is confident that the price of Stock A is going to rise throughout the day. Employing the scalping strategy, he buys a large amount of Stock A at $15 and sells it once it rises to $15.05. He buys it back again when the price rises to $15.10 and sells it the moment it hits $15.15. He continues to do this until the stock price shows signs of dipping, or when he’s ready to exit.

Some day traders prefer this strategy because it hedges against the risks of larger price drops, and allows for the gradual accrual of profit. At first glance, making 5 cents off a trade might not seem like a lot. But, if a trader is buying and selling a large volume of shares, say 1000—sometimes with an algorithm or bot—then their return per trade will amount to a significant amount of profit.

Range Trading 📊

This strategy takes advantage of trading ranges—the upper and the lower price limits that a particular stock trades at. Of course, not all stocks will fall under a trading range, and all trading ranges break off one way or another. However, one can take profit from a short-lived trading range.

When using this strategy, a trader analyzes stocks for specific patterns—including certain figures in terms of price and or trading volume. If a stock reaches $50 per share and rebounds down to $45, only to grow back to $50, then a potential trading range has been identified. Once the stock’s price action performs that rebound a couple of times, a trading range is clearly visible. Identifying this trend provides traders with better odds in predicting future price movements.

However, it’s important for a trader to have a solid exit strategy and hedge their trades properly. These trends always end sooner or later.

News-Based Trading 📰

This strategy is more about the source of information a trader uses for decision-making rather than the specific way of making market orders. As the name suggests, a news-based day trader waits for the news announcement about the company, or the industry it’s in, to capitalize on the market response.

For instance, if news comes out that a company which has had solid earnings reports for years is in the middle of a scandal, the stock price will probably drop in the near-term. That creates an opportunity for a day trader to swoop in and take profit in the small fluctuations of the market.

News-based trading requires a lot of prior knowledge of both the market, the company or commodity that’s the subject of the news, and other trading strategies that are best implemented in each specific scenario. Investors also need an automated news feed for delivering fast news alerts.

High-Frequency Trading 📈

Trading based on news signals requires a lot of knowledge and judgment on the part of the trader. This strategy is almost the opposite of that, with most of the decision-making coming from a program, typically some sort of artificial intelligence (AI). This program judges the market conditions and executes hundreds upon hundreds of trades per day. Hence the name, this type of trading requires a high frequency of trades to be profitable.

Unlike typical day trading software, an AI for high-frequency trading solely requires the trader to input specific criteria, and off it goes. A trader must initially provide it with conditions for making a purchase and stop-loss order conditions. After that, all they have to do is monitor how well their algorithm is performing and change the conditions if necessary.

Needless to say, some of the programs, especially the high-end versions can be rather expensive, so one needs to include not only the commission but also the price of the software into their profitability calculations. If a trader can sign up with a broker with little to no costs this could go a long way for them because fees and taxes can eat up one’s revenue.

Day Trading Regulations 👩‍⚖️

Learning and mastering strategies let you know what to do. Understanding the basic rules of day trading lets you know how to do it properly. Here are several rules that are crucial for a modern-day trader.

How Much Money Do I Need to Day Trade? 🤔

As per FINRA regulations, once a trader is designated a pattern trading account, their broker will not let them continue trading unless their account has at least $25,000 worth of equity. This doesn’t have to be $25,000 in cash; traders can also hold securities worth that sum. Should the value of this portfolio fall below the minimum required limit, the trader will be blocked from trading until they add additional funds or financial assets.

Also, don’t forget that a trader doesn’t have to conduct hundreds of trades to fall under that category. It only takes four intraday trades within a five-day period for one to be considered a pattern day trader, as long as it represents over 6% of their account’s volume. A small account can easily fall under that rule.

These regulations are implemented because day trading is inherently risky and is done on a margin, meaning the trader can lose more than their cash investment. The broker must cover the trader’s position when they’re at a loss and can liquidate positions in the account to do so, so asking them to have cash ready to pay for lost trades is only fair.

Margin Trading Explained 📙

Margin trading takes place when an investor trades a financial instrument with borrowed funds from a broker. The “margin” is capital borrowed from an investor and forms the difference between the total value of an investment and the amount loaned. In order to participate in margin trading, a trader must have a margin account and not a standard brokerage account.

Some traders opt for this strategy because having access to a bigger account means more opportunities to grow capital from their investments. Not everyone can start trading with large sums of capital they’ve saved up, which is where margin trading can come in. Buying on margin also makes it much easier to invest in blue-chip stocks with expensive price tags, which could mean more profits if the investor knows what they’re doing.

When a trader borrows from a broker, the current cash or financial assets in their account becomes the collateral for the loan and comes with an interest rate that must be paid. Margin requirements for day traders depend on the type of security that is being purchased but do not exceed 15% in most cases, FINRA explains. 

It should be noted that while this strategy can provide investors with more opportunities, it also offers a great amount of risk. This strategy is not ideal for traders who are still trying to learn the basics of investing, because it could lead to very expensive mistakes.

Day Trading Buying Power ⚡

When it comes to buying power, there’s an important restriction for traders to consider. An account’s buying power is limited to four times the excess of the security deposit. That means anything that’s over $25,000 at the end of the day is multiplied by four to calculate an investor’s buying power.

For instance, if by the end of the day, an investor has $30,000 in cash and securities in their trading account, their buying power is 5,000*4 = $20,000. That’s the maximum sum one can hold in day trading deals simultaneously. It doesn’t mean they can’t do multiple deals that exceed that number when combined, an investor can’t just hold more than $20,000 worth of stocks at any given time.

If that limit is broken, an investor may face harsh action from their broker, which can include being asked to increase their deposit from $25,000 to $500,000.

Day Trade Call Explained ⏳

When day trading limits are broken, the trader will be under a day trade call. The trader will have two days to cover the call, on the third day their day trade buying power will be restricted to 2x excess in the account. To cover the call, the trader needs to either deposit the amount of the call in cash or sell enough securities to meet the call.

However, if they do the latter too much (three times during a 12 month period), that trader’s buying power will be restricted to 1x the excess of the maintenance deposit. Keep in mind that if a trader holds securities overnight, the buying power restriction does not apply.

When Does Day Trading Become Pattern Day Trading? 🧐

Pattern day trading can be a complex subject to understand, so it’s best to provide an example. Below, you’ll find two examples of trading behavior — one that falls under the definition of pattern day trading, and one that doesn’t.

Not Pattern Day Trading: An Example 👨‍💻

Jake buys 100 shares of Netflix on Monday and sells them two hours later the same day when he sees a sufficient rise in price. On Tuesday, he purchases 500 shares of Apple with the intention of selling them a couple of weeks later, but the price starts falling due to negativity in the press so he decides to cut the losses and sell half of them.

On Wednesday, he sells the rest at a profit. He purchases 400 shares of Netflix the same day and issues four options to hedge against the risks of a short-lived downward momentum.

In this example, our hypothetical investor only did one intraday trade on Monday. Tuesday’s trade was a swing trade, and he intends to hold the shares he purchased on Wednesday for a longer period of time.

However, with a few minor tweaks, Jake can be labeled a pattern day trader. If instead of selling half the shares on Tuesday, he sold all of them in an effort to cut the losses, this would be counted as a day trade. Then, if the Wednesday covered call raises in price and Jake has to sell shares as per the option contract, it would constitute his third day trade of the week.

Now, his account is one day trade away from being flagged as a pattern day trader, even if Jake isn’t trying to be a day trader.

A Clear Example of Pattern Day Trading 📝

Jack buys 100 shares of Netflix and sells them as soon as the price rises by 10 cents. He then gets a notification about negative publicity regarding Apple and since his broker is great for short selling, he decides to short Apple through 200 shares, liquidating his position as soon as he gets 15 cents of profit per share.

An hour later, Jack notices that Netflix shares start following a trade range and hops on the downward trend, making 60 cents per share in profit. Seeing that overreaction to news about Apple is wearing off, he purchases 200 shares of Apple, holds them for an hour, and sells with 30 cents profit. With these sell orders executed, Jack finds a penny stock with rapidly increasing capitalization and executes five trades, making a loss on the last two before calling it a day.

With all of that happening in a single day, Jack is undeniably a day trader.

What Happens if I Accidently Become a Pattern Day Trader? 🤔

Since the criteria for being flagged a pattern day trader are not extensive, it’s not uncommon for novice traders to accidentally become PDTs. All it takes is a few misplaced stop-loss orders, and a trader will receive a request from their broker to deposit $25,000 or face account closure.

If this was a result of a mistake on the trader’s part, then he or she will need to contact their broker as fast as possible and explain the situation. “Accidental” pattern day traders may have to sign a couple of agreements promising to never perform day trading again, and the broker will then let them off the hook. In most brokerage firms, traders can do this a couple of times per six months.

If that’s not an option, an investor has two choices: deposit $25,000 and continue trading, or be prepared for their account to be barred from making day trades for the subsequent 90-day period.

Will I Pay More Taxes as a Day Trader? 🏦

The short answer to this question is yes. But it requires a more complex explanation. Investors who receive their profits from holding assets long-term (more than one year) have a more privileged position in terms of taxes owed on capital gains from selling stocks. Long-term capital gains do increase adjusted gross income which may disqualify traders from certain tax cuts and exemptions, but it’s counted separately from general income.

So, if a trader receives $60,000 annual income from their day job and make an additional $40,000 on selling stocks which were held long-term, they’re not paying taxes on that $40,000 in a higher tax bracket. One will only pay taxes on the day job income like they would normally do, and count the income from selling stock separately. This is as long as they’ve held on to those positions for more than a year (spoiler alert: day traders don’t do this). 🔔

As per the Tax Cuts and Jobs Act, they pay nothing for income below $41,675, and 15% on income below $459,750 if filing as a single person. Anything beyond that sum is taxed at 20%. This is a very lenient tax code, and it’s done this way to encourage investors to hold stock long-term, because it helps with supporting the economy.

On top of that, long-term investing can provide a lot of other tax benefits. For instance, if an investor finds a broker who sells Roth IRAs, they can invest and grow their capital through tax-free gains.

Day trading, on the other hand, is speculation and does feature the economic benefits of long-term investing. Therefore, the IRS is not interested in providing tax benefits to short-term day traders—or, more generally, investors who hold assets for less than one year.

Short-term capital gains are added to their gross income and are taxed just like regular income. This means that an investor could end up paying up to 37% tax on their day trading revenue. 💵

Needless to say, one can deduct any losses and commissions from the capital gains. Still however, the situation is clear: active day traders will typically pay much more in taxes compared to long-term investors.

Understanding The Wash Sale Rule 👨‍🏫

There is a route some traders take to alleviate their overall tax burden, known as tax-loss harvesting. The goal of tax-loss harvesting is for a trader to minimize the capital gains tax on their portfolio, so that they can keep as much of the money earned trading as possible.

In its simplest form, tax-loss harvesting involves selling securities that are performing poorly, in order to lower one’s overall tax burden. Traders can use capital losses from poorly performing assets to lower the amount of tax they have to pay on capital gains. 

This method of “saving” on taxes is favored among traders because one doesn’t need to have significant funds in their account to use this strategy. Additionally, some investors even use this method to offset the taxes on their regular income.

Understandably, the IRS is not keen on the idea of investors using alternative methods to “skirt” taxes. Hence, the implementation of the wash-sale rule:

According to the IRS, when an investor sells a security at a loss, they are not permitted to purchase “substantially identical” shares within 30 days of the sale, or 30 days after the sale has been completed. Should an investor attempt to report the loss as a deduction, the IRS will not allow it and the trader will not receive any tax advantages from the sale.

So, day traders may have viable “alternatives” to alleviate their tax burden, but it’s important to understand that these options come with risks and hefty consequences. It’s also particularly important for new traders to understand that tax-loss harvesting won’t erase their taxes on capital gains, it will only defer it to a later time. 

Can You Day Trade With Less Than $25,000?

Day trading without complying with the FINRA regulations is not possible unless one is trading outside of the U.S. If that isn’t an option, then U.S.-based traders will have to follow every word of the regulations. This does leave some breathing room, though. 💨

First off, a trader can execute up to three day trades within five business days. The sum total of the trades is not restricted, so if Cody does three large day trades per week and receive large profits, it can work for him. But most day trading strategies are focused on doing multiple trades per day, sometimes hundreds of trades, so this way of trading does not fit every day trader.

The other way of going around the rules is trading with multiple brokers. This way an investor can execute multiple trades per week across different trading platforms. This strategy is also flawed as day trading often requires fast decision-making and it’s not possible to do this when one’s trades (and capital) are spread across multiple accounts. 👥

The last way to practice short-term trading without depositing $25,000 into your account will require a bit of a compromise. If a trader holds assets overnight, it’s not considered a day trade. This means if a trader considers swing trading to be a good strategy, they can trade without having to deposit $25,000. Of course, it’s not day trading, but it’s as close to it as one can get without being required to deposit a large maintenance sum of capital.

Final Word: Is Day Trading Right for You? 🏁

While day trading can be a viable way to practice short-term trading, it can also be a risky one. It all depends on how well a trader knows the market and whether their trades are successful. Knowing how to establish a decent hedging strategy is also crucial. Therefore, day trading is only recommended for experienced traders.

If you’re only starting to trade, placing highly leveraged trades, especially on volatile assets, can lead you to shaky grounds. Instead, try to gain experience by using a more reserved trading strategy or by experimenting with a paper app for stock trading.

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