What is Buying Power in Day Trading?
Buying power is the amount of purchasing power available in your account after accounting for all transactions and the effects of margin. Margin is the ability to borrow based on the equity in the account. The determination of margin varies based on the type of security and the security's volatility. Recent rule changes have enhanced the ability of day traders to employ margin, and thus create more buying power.
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Day-Trading Effects on Buying Power
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An investor who owns $10,000 in stocks and $5,000 in bonds has buying power if he chooses to use margin. Margin allowances of $5,000 (50 percent) for stocks and $4,000 (80 percent) for bonds are available for additional investment. The $9,000 total can be for additional stock, bond and option purchases. If used, these purchases also will create a residual amount that can be borrowed for additional purchases. Margin requirements change from time to time and, as a result, so does buying power. Buying power changes with every change in a securities price.
The Pattern Day Trader
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The ability to day trade was often limited by the amount of buying power in an account and the brokerage rules in place by the brokerage firm. The Financial Industry Regulatory Agency (FINRA), the successor agency to the National Association of Security Dealers (NASD), created a special designation, "pattern day traders," enabling greater margin for day traders in return for greater account control.
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Pattern Day-Trading Requirements
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FINRA recognizes day trading as the opening and closing of a stock position during the same trading day. Pattern day trades do not apply to bond and mutual fund positions. In addition, the trader must make four or more day trades in a rolling five-day period. Day trades must exceed 6 percent of your account value, or the investor does not qualify for the pattern day-trade position. A minimum account balance of $25,000 is required to be maintained at all times.
Benefits of Qualifying as a Pattern Day Trader
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Rather than receive margin of 50 percent for stocks, the advantages of pattern day trading are substantial. Traders may purchase qualifying securities up to 400 percent of the total amount of excess liquidity. This allows substantial leverage opportunities. Given that it is possible to trade index-tracking stocks that themselves are leveraged up to three times their asset value, the trader has little need for the greater intrinsic riskiness of options and futures. This, of course, is what the exchanges want--to bring more money back to the exchanges for trading.
Day Trading in Cash and Retirement Accounts
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While day trading can occur in cash (not margin) accounts and retirement accounts, it is not practical to do so. This is because, unlike the pattern day trader in a margin account, the act of settling a buy-and-sell account occurs on the third day after the transaction takes place. This is known as T + 3. Options trade as a T + 1 transaction. The effect is that buying power is reduced by the amount of the transaction until the transaction settles. Thus, while a security can be bought and sold the same day, the amount of the buying power reduction is not changed until settlement day.
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