- Pattern Day Traders vs Non-Pattern
- Why “Pattern” vs. “Non-Pattern” Matters
- Having Realistic Expectations
- Final Thoughts
Day trading on margin uses borrowed money to leverage trading results and could be very risky without the proper knowledge and experience. When you trade on margin, essentially you are using borrowed money with a good faith deposit to open and maintain positions in one or more currencies. Margin trading is not a suggested practice for beginner or novice traders who haven’t been in the industry for a significant amount of time because it takes a more experienced trader to establish effective strategies and risk management practices.
Margin trading is utilized to capitalize on gains and losses and amplify trading profits. However, trading, like any sport, should focus on the defense primarily because looking at it with your defense in mind will keep you in the game for the long haul.
Often times, day traders will make several transactions each day to benefit from small fluctuations in the market. The risk to trading with leverage is that it could wipe out a significant fraction of your trading funds in a very short period of time if you enter into a losing streak and the market moves against you.
For day traders with longer holding periods, the available amount you can borrow in your account is different depending on your position in the market. Typically, day traders can borrow up to 4 times the minimum equity requirement of the amount originally deposited into their account according to standard Regulation T (“Reg-T”) rules. There is also an increase for traders who hold positions overnight, which is 2 times the minimum equity requirement of the original deposited amount. That being said, it is wise to check with specific brokers and rules or regulations of the jurisdiction you are in to determine what those guidelines are. (More on this below.)
The general idea behind allowing day traders to borrow significantly higher amounts than loner-term traders is that shorter holding periods are much less likely to end in a security moving in a material way because then the potential loss on any given position decreases. Therefore, there are some stipulations that exist requiring positions be closed overnight when this happens. When this occurs, any leverage beyond what is permitted for overnight trading will be lost and the funds will be automatically liquidated by your broker.
Pattern Day Traders vs Non-Pattern
Different types of day traders come with different sets of rules and regulations, and many times these rules and regulations could be very different from one another. Generally, there are two main distinctions; those considered “pattern day traders” and those considered “non-pattern day traders”.
Pattern day traders are traders who execute four (4) or more trade transactions within five (5) business days and meet one or more of the following qualifications:
a) Within the same five business days, the number of total trades in a traders margin account is above 6%. This means if a trader initiates 4 day trades within one week and fewer than 67 trades of other types (which would satisfy the 6% rule), this trader would qualify as a pattern day trader.
b) Within 90 days of the qualifying 5 business days, the trader engages in 2 unmet day trade calls. Basically, this means their trades go above the buying power limitation more than one time within a 90 day period.
c) An individual trader can also be designated as a pattern day trader simply at the discretion of the brokerage firm you are trading with. If the broker believes a trader should be classified as a pattern day trader, they have the ability to solely make that decision based on their discretion. For example, this could happen if the brokerage firm has provided all the necessary training to individual traders that they feel is necessary prior to opening an account in their own name. Therefore, they feel the individual is automatically qualified as a pattern day trader since they personally provided all of the necessary educational tools.
More frequently asked questions about this matter can be found on the official FINRA website.
Once the above qualifications are met and the account status is changed to a pattern day trader, it is very important to remember to execute trades regularly to remain in good standing and keep this pattern day trader status. Once an individual is considered a pattern day trader, you must execute at least one trade each 60-day period. If this is not met and no trades are executed in 60 consecutive days, the account will be switched from a pattern day trader to a non-pattern day trader automatically.
When a trader does not meet the above qualifications, they will receive a non-pattern day trader classification.
Why “Pattern” vs. “Non-Pattern” Matters
The simple answer is the margin requirements. For pattern day traders, the margins are notably higher, which means pattern day traders’ minimum equity requirement is much higher than non-pattern day traders. In addition, pattern day traders must aquire either a minimum of $25,000 or 25% of the total market value of the securities in their account, whichever is higher. On the other hand, non-pattern day traders are given a minimum equity requirement of a standard rate of $2,000. In the event that an account falls below it’s minimum equity requirement at any time, trading is suspended until the minimum amount is achieved.
As mentioned before, pattern day traders have the ability to purchase up to 4 times the amount in addition to the $25,000 minimum equity requirement. An example of that would be if $40,000 is deposited into an account, that would be $15,000 higher than the requirement of $25,000. When you apply pattern day trader allowance of 4 times the amount left over, which would be $15,000 in this example, the account can now trade up to $60,000 worth of securities.
If this amount is exceeded, the broker will issue a margin call. Once that is done, the trader is given 5 business days to decrease the amount of securities owned to a satisfactory level. Often times, this will automatically be done by the broker by liquidating positions until the account is back in good standing in accordance with the set rules and regulations. During the period of time between a call being issued and the 5-day limit to resolve it, day trading will be reduced for this specific account to only 2 times the excess of the maintenance margin. If a trader fails to reduce securities to comply with these requirements within those 5 business days, trading will be limited to a cash-only restriction. This restriction will stay in place until the margin call is met, at which time the cash-only restriction will then be reversed.
Margin calls will be sent out for any account when the buying power has been breached, regardless if positions were sold that same day. This means, if a trading account has $25,000 in excess of the maintenance margin and the trader decides to buy $110,000 in stock, which would exceed the 4 times stipulation, a margin warning will be issued or margin call either immediately or the following business day. The margin warning or margin call will be automatically initiated, even if the trader buys and sells the position within the same market hours.
Please advise that these rules and regulations are not a blanket statement across the board when it comes to day trading. Depending on the juristidiciton in which you are trading, the broker, or the brokerage firm, rules and regulations are liable to vary. Brokers have the freedom to create their own set of rules and regulations that deviate from the standard trading rules. Basically, what this means is that they have the ability to modify current rules that exist and/or adopt rules of their own in order to protect their own personal business interests. Sometimes this could mean broadening qualifications to be considered a pattern day trader, how they enforce minimum equity requirements, or the ability to restrict buying power of certain accounts. As a result, you should always double check with your broker or brokerage firm prior to creating an account to be sure you understand exactly what the rules and requirements are and what specific exceptions to those rules or additions to those rules may apply.
Having Realistic Expectations
As a day trader, understanding the level of risk is paramount. Any fluctuation in the price of owned securities, regardless of how big or small, can lead to outsized moves in the price of your portfolio.
Margin trading grants traders the ability to trade with money that is borrowed and not rightfully theirs to help with issues of undercapitalization that happens with many traders. However, traders must have a solid trading strategy and be able to utilize effective risk management strategies in order to benefit from these borrowed funds. Without these practices in place, borrowed funds will not solely result in making more money without a proper plan in place to attain and manage those funds appropriately.
If you plan to utilize the trade market as a “get rich quick” scheme, it will not work out in your favor and it is not realistic. In order to be able to make a living in this industry, it requires having a significantly large capital base. It is not possible to make a substantial amount of money with just a few thousand dollars. This requires a level of understanding and planning if traders want to be successful and make a large sum of money. Starting with how much income will be required from trading and dividing that by the expected percentage return each year, traders can determine a rough estimate of how much of a capital base would be needed in order to make a living day trading.
To put this into perspective, the S&P 500 is expected to return about 7% per year in nominal terms moving forward. Most hedge funds, which employ very knowledgeable and experienced investors, fail to reach these terms. Reaching this mark could potentially be a realistic goal. So, if one were to need $50,000 per year to meet their income goal, this would require a capital base of slightly more than $700,000 ($50,000 / 0.07). And note that markets don’t consistently give you X% return per year. Without a doubt, there will be fluctuations in the market, sometimes very significant ones. This means traders absolutely need a solid and dependable strategy as well as risk management skills and techniques in order to come out on top. There is no such thing as a safe 7% return, even though day traders often follow volatile markets such as equities, commodities, and/or currencies.
Nonetheless, when properly utilized, margin trading has the potential to increase expected returns into a risk level the trader is more comfortable with. It could also be a safer option than cash-only trading as far as incentives go that illicit low to moderate risk strategies as opposed to higher risk strategies to compensate the difference. Knowledge of the leverage will help to increase any gains that are made instead of high-risk strategies, such as taking large concentrated positions in high-risk securities.
Day trading on margin can definitely be risky and beginner traders are cautioned to steer clear until more knowledge, strategy and experience could be obtained. However, for the more experienced traders with profitable trading strategies and a solid plan in place, using low to moderate amounts of leverage can actually be less risky than using no leverage and pursuing returns with ineffective trading strategies.