Regulation of Day Trading
Day trading is the buying or selling of investments with the goal of holding the position for less than a day before closing the position at a profit. Day traders use different markets to practice their trade, including foreign exchange of currencies, or forex, stocks, options and futures. Currency traders work with unregulated banks and brokers, and futures traders have the same regulations for all traders. The stock and options market have designated regulations for day traders.
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Identification
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The Securities and Exchange Commission and the Financial Industry Regulatory Authority (FINRA) use the term "pattern day trader" to determine if an account falls under the day-trading regulations. A pattern day trader is defined when four or more day trades are made in an account during any five-day period. A day trade is when a position is opened and closed during the same trading day. A broker is also required to designate an account as a day-trading account if the broker believes the account will be used for day trading.
Leverage
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All forms of day trading require leverage to generate trader profits from the relatively small price moves securities make during a trading day. Stock and option traders use margin accounts that allow them to borrow a portion of the trade cost from the brokerage. Regular margin accounts are allowed to have two times leverage or borrow half the cost of any trade. Day traders are allowed by FINRA rules, up to four times leverage on trades that are closed by the end of the business day.
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Equity
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SEC regulations require a minimum investor or trader equity of $2,000 in a regular margin account. For pattern day-trading accounts, the minimum equity is increased to $25,000. Equity is the amount of the trader's own money in an account. Equity can also be calculated as the value of the account less the amount borrowed from the stock brokerage on margin. Since day traders close out their positions before the end of the trading day, these accounts should have a cash balance greater than $25,000 at the end of the market day and before the market opens the next day.
Considerations
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Traders who fall below the minimum $25,000 equity will have their account restricted to closing trades only for a minimum of 90 days or until money is added to return the trader's equity back to more than $25,000. Day traders can have profits and losses during any trading day, so a trader should keep a cushion above the $25,000 to keep her trading account active after a losing day. Also, traders that use their equity to support four-times day trading leverage cannot withdraw the equity funds for at least two business days after trading. A trader with $50,000 equity in his account could have position values up to $200,000 during the trading day. If he wanted to withdraw $10,000, he would have to limit his position level to $160,000 ($40,000 times 4) for the two trading days, freeing up $10,000 of equity to withdraw.
Warning
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The Securities and Exchange Commission warns that day trading is a stressful, full-time job in which many traders never reach the point of making profits from their trading. The use of leverage and the short-term nature of day trading can result in significant financial losses. The SEC also warns against believing any claims of easy profits from sellers of trading systems.
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References
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