Many investors in the stock market buy stocks and hold onto them for long periods of time — known as a “buy and hold” strategy. Other investors buy and sell stocks on the same day, which is known as day trading. Buy-and-hold investors are betting on the stock market’s natural tendency to go up over time. Day traders, by contrast, attempt to take advantage of daily price fluctuations for financial gain through short-term market movements.
As with any big financial decision, you want to know your ultimate goals before you head down that path. Part of that is outlining your investment objectives. For example, are you looking to purchase stocks and mutual funds and hold them until retirement, or are you looking for quick returns?
If you chose the latter, pattern day trades might be the thing for you. However, be aware that the risks associated with multiple trades in one day make the practice much more akin to gambling than investing for your future.
Read on to learn more about day traders, what the requirements are to become a pattern trader, and the risks inherent in this type of investing practice.
What is pattern day trading?
Anyone who buys and sells the same stock within the same trading day is considered a day trader. A pattern day trader, on the other hand, is defined by the Financial Industry Regulatory Authority (FINRA) as “any customer who executes four or more day trades within five business days, provided that the number of day trades represents more than six percent of the customer’s total trades in the margin account for that same five business day period.”
The Securities and Exchange Commission (SEC) points out that the rule only constitutes a minimum requirement, and some brokerage services may use a broader definition to determine if investors qualify as pattern day traders. Because of this possibility, it’s recommended that customers check with their brokerage firm to figure out if their trading style falls under the wider definition.
If you do not meet FINRA requirements for pattern day trading, you are only allowed to buy and sell stocks same day three times in a five-day period. Cash account holders are also not allowed to day trade more than three times during five business days.
The rule also requires investors to be tagged as pattern day traders if the broker knows or has a “reasonable basis to believe” that an investor may engage in pattern day trading. Guilty until proven innocent, if you will. This could happen, for example, if a broker gave training to a client about day trading before they opened an account. Because of that, they might designate the investor a pattern day trader because they reasonably expect them to engage in habitual day trading behavior.
Margin requirements for pattern day traders
There are a number of requirements that need to be met if you want to make regular day trades a part of your investment strategy.
Minimum account equity
To start with, pattern day traders must have margin accounts and keep a minimum of $25,000 in their margin account on any day they want to purchase stocks and trade them. FINRA rules state that the $25,000 can be a mix of cash and eligible securities.
If the account minimum net worth ever falls below that, a customer wouldn’t be allowed to buy and sell a stock on the same day until the margin account is topped up.
Day trading buying power
Buying power for pattern day traders means you’re typically allowed to trade up to four times your maintenance margin excess as of the close of business of the previous day. The margin excess would be anything over the $25,000 minimum. So if a trader had $30,000 in the account, that would be $5,000 in excess and the investor would be able to day trade on the stock market using a maximum of $20,000 for that day.
If you exceed the buying power limitation, you will get a margin call from the brokerage. A margin call is a demand for money to bring margin accounts back to their maintenance level. A client then has a maximum of five business days to deposit funds and meet the call.
In the meantime, you would only be allowed to trade a maximum of two times the maintenance margin excess based on your total daily trading amount. If the day trading call is not met by the deadline, the account will be further restricted to only trading on a cash basis for 90 days or until the call is met.
Risks of habitual day trading
Other than the very real risk of losing piles of money in minutes that comes with making multiple trades in a day, there are a few consequences other high-volume traders should be aware of.
Although day trading has a lot in common with gambling, one important difference is that you don’t have immediate access to the returns when you “win.” First, you have to wait through the settlement period, which is usually two to three days. What this means for regular investors is that the money won’t be deposited in their account for at least a couple of days, which isn’t usually an issue.
Therefore, pattern traders often won’t have those funds available for further trading. In that case, an investor might want to borrow money from their account to continue investing, and they will have to pay interest on those borrowed funds. If all doesn’t go as planned, that only adds to an investor’s risk and total debt incurred.
Tax consequences of day trading
People that engage in day trading, and are successful at it, will likely be on the hook for significantly more taxes than long-term investors. It’s important to be aware of the tax implications that may impact your gains from stocks traded.
If an investor holds a stock for longer than a year and then sells it, that is considered a long-term capital gain by the Internal Revenue Service (IRS). Because it’s long-term, it’s generally taxed at no higher than 15%, assuming you don’t exceed certain income thresholds. That being said, it would never be higher than 20%.
If you’re buying and selling as a day trader, any profits you make are designated short-term capital gains. Those profits are taxed at your ordinary income tax rate, which could be as high as 37%.
Should you consider day trade practices?
Generally speaking, this type of stock trading — buying and selling stocks on a daily basis — is not a good strategy for individuals with limited resources, minimal investing experience, and a low tolerance for risk. Even experienced investors know the very real possibility that they could lose all of their available stock trading money in a single day.
Some investors can afford to take that risk, but your average retail investor usually can’t. Regardless of the decisions you make around your investment goals, do your research and talk to some investing professionals before embarking on this highly risky type of investing.
What happens if I buy and sell a stock on the same day?
Anyone with a brokerage account can buy and sell a stock on the same day. However, it’s when you start doing this excessively that you get labeled a day trader, or a pattern day trader, and then must deal with the consequences and restrictions of that type of investing strategy.
To get around the day trading rules, some retail investors will buy a stock near the end of the day, knowing they can turn around and sell it after the market opens the next day. This is not considered a day trade because they’re buying and selling stock on two different days.
What is the 10 a.m. rule in stocks?
Institutional investors know that trading volume tends to be highest in the first and last hours of the trading day. The 10 a.m. “rule” says stocks that open at either higher or lower than they closed the previous day tend to continue this trend for the first five or ten minutes after opening the trade day. After that, barring any significant news event, stocks tend to reverse their course for the next 20 minutes or so.
This means that, theoretically anyway, by 10 a.m., you should have a better idea of whether the beginning trend will continue its course or reverse itself.
Is it okay to buy and sell the same stock?
There are no rules against buying and selling the same stock or stocks over and over or throughout your whole lifetime, even. As long as you don’t regularly place both a buy and a sell order on the same day, you won’t get into any issues with the Securities and Exchange Commission.
- A day trade is when an investor buys and sells, or sells and buys, the same stock on the same trading day. Investors who do this are known as day traders.
- A pattern day trader is an individual who makes four or more day trades within five trading days. The amount from these sales must also come to more than 6% of total trades for that same time period.
- Day trading, particularly pattern day trading, is an attempt to take advantage of short-term stock prices for immediate financial gain and is considered an extremely risky investment strategy.
- In addition to the risk of quickly losing money when you buy and sell the same stock on the same day, the capital gains taxes are much higher than with long-term stock positions.
View Article Sources
- Am I a Pattern Day Trader? — Financial Industry Regulatory Authority
- Thinking of Day Trading? Know the Risks. — U.S. Securities and Exchange Commission
- Margin Rules for Day Trading — U.S. Securities and Exchange Commission
- Topic No. 409 Capital Gains and Losses — IRS
- What Is Scalping In Trading? Strategies and Examples for Beginners — SuperMoney
- What Happens When a Call Option Expires? — SuperMoney
- What is a Margin Loan and How Does It Work? — SuperMoney
- What is a Stock Float? Examples of High Vs. Low — SuperMoney
- What is Averaging Up And Down In The Stock Market? — SuperMoney
- What Is a Pullback? Meaning and Trading Examples — SuperMoney
- Buy To Open Vs. Buy to Close: How Does It Work? — SuperMoney
- What is Short Interest? — SuperMoney
- How to Avoid Capital Gains Tax on Stocks — SuperMoney
- Five Key Principles Of Smart Investing — SuperMoney
- How To Invest In The Stock Market: 8 Basic Concepts — SuperMoney
- Best Brokerage Apps — SuperMoney
- Beginner’s Guide to Investing — SuperMoney