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Day Trading Rules and Leverage

An explanation of pattern day trading and the role of margin leverage.

What is a Pattern Day Trader?

In 2001, the rules for Day Trading were significantly changed based on how frequently an online trader makes this kind of trade. If a trader exceeds a certain number of day trades within a short period of time, the trader's brokerage firm is required to mark the account as that of a Pattern Day Trader (PDT). Certain restrictions may apply to these accounts.

A Pattern Day Trader is one who makes more than three day trades within a rolling five business day period. The first time this trade limit is exceeded, TradeKing permanently designates it as a Pattern Day Trade account. If a trader makes only three day trades or less during this period, he or she is not considered a Pattern Day Trader.

There are both pros and cons to having a Pattern Day Trade account. Because of this, a trader may elect to be labeled as a Pattern Day Trader before exceeding the three day trade limit. Since the number of trades is such an important factor, it is critical for the online trader to understand exactly what kind of activity constitutes a Day Trade.

What is a Day Trade?

A Day Trade consists of two off-setting transactions which occurred in the same security on the same day. The order of these transactions must be opening followed by closing. This sequence must be maintained to meet the definition of a Day Trade. The trading session in which they occurred is not important. Pre- and post market trades are treated the same as regular session trades. With regard to time, all that is relevant is the trades occurred on the same day and positions are not held overnight.

The Number of Day Trades is Important

The quantity of shares traded or number of orders placed can sometimes complicate this definition. In essence, the total number of day trades on a given day in a specific security is determined by the lesser number of opening or closing transactions. To be clearer, here are a few examples to illustrate this. All of these scenarios hold true irrespective of opening with a long or short position.

If a trader opens a stock position with one order of 1000 shares and exits the position with two 500 share orders, these three trades are grouped together as one day trade. (One trade is the lesser amount.)

If a trader opens a position with two 300 share orders, the trader has a position of 600 shares. If this position is liquidated with one order of 600 shares, this series of trades is also considered one day trade. (Again, one trade is the lesser amount.)

However, let's say the same trader again creates a position with two 300 share orders. Although a similar holding of 600 shares is created, two day trades will result if the trader closes out with two 300 share orders. (Two transactions on each side so two trades is the amount.)

If any of the orders mentioned above are filled in multiple transactions, this alone does not affect the number of day trades taken. For example a trader placing an order to close a position of 600 shares may receive confirmations on 200 and 300 shares with 100 shares still open. All 600 shares will be considered one transaction, provided the trader does not modify the remaining order balance of 100 shares. If the trader makes changes to the partially filled order, it will be classified as a brand new order. If this new order becomes executed it will create an additional day trade.

When the Number Exceeds Three Day Trades

If a trader makes four or more day trades in a rolling five business day period, the account will be labeled immediately as a Pattern Day Trade account. Certain limitations will then be applied based on the account equity. (Account equity is the amount of cash that would exist if every position in the account was closed. This is also known as the liquidation value.)

The most infamous one is the requirement to maintain minimum account equity of $25,000. If the trader can maintain this minimum, the trader may day trade as frequently as desired. However if the trader makes more than three day trades in this period without maintaining the minimum balance, the account will become restricted from day trading and all positions must be held overnight. (There is no limit to the number of trades if you hold the position overnight.)

Increased Leverage: A Possible Advantage of Pattern Day Trade Accounts

If the trader can maintain the minimum balance requirement of $25,000, there are certain benefits for this type of account. Increased access to margin and therefore increased leverage can be one of them.

For non-pattern-day-trade accounts with standard access to margin, traders may hold positions in value up to twice the amount of cash in their account. For example if the account has $30,000 in cash, the trader can buy up to $60,000 worth of stock. The trader uses the $30,000 and the brokerage firm lends the trader the remaining $30,000 on margin and charges interest on the loan.

Pattern Day Trade accounts will have access to approximately twice the standard margin amount when trading stocks. This is known as Day Trading Buying Power and the amount is determined at the beginning of each trading day. When trading stock, Day Trading Buying Power is four times the cash value instead of the normal margin amount cited above. So in the previous example, the trader would be able to trade up to $120,000 worth of stock.

Beware though, there is a caveat. In the first example with the standard margin account, the trader may hold the position overnight. In the second example, the positions must be reduced to standard margin levels if the positions are not closed the same day. This means the holdings valued at $120,000 must be reduced to $60,000 (or less if there are trading losses) in order for the trader to continue to hold the positions into the next day. This is because Day Trading Buying Power can only be used when Day Trading. Even if the trader intended the positions to be day trades, but the trader does not exit before the market closes, these are no longer day trades. Either the trader will need to meet the overnight margin requirement of 50% of stock value, or the brokerage firm may take action to liquidate holdings in the account in order to bring it inline with federal and/or local margin rules. The term Day Trading Buying Power sounds simple enough, but many traders have been known to somehow "forget" the capital is for Day Trading only.

Leverage: A Double-Edged Sword

Leverage and margin are trading tools and are meant to be used wisely. Financially speaking, leverage is when a small amount of capital is able to control a much more expensive asset or group of assets.

When trading and investing, leverage has the ability to magnify the skill set of the trader. If the trader is adept and able to profit while trading, leverage (margin) may help the trader to make profits faster and/or in larger quantities. However the reverse is also true. If the trader is not proficient and racks up trading losses, he or she will do so more quickly and in larger amounts when using margin.

When you day-trade with borrowed funds (margin/day trading buying power) it is possible to lose more than your initial investment. A decline in the value of stock purchased may cause the brokerage firm to require additional capital to maintain the position. Absence of an immediate additional capital infusion may cause the broker to liquidate client positions at its discretion. Likewise, the same can happen with a short stock position. This can result in an unlimited losses. So although access to increased margin with a Pattern Day Trade account can be beneficial, there is no guarantee that the account will be profitable. In addition, a trader will be able to make more transactions due to the increased access to trading capital. Since expenses can pile up quickly, it is crucial for Day Traders to monitor and control this expense as best they can. Having an online discount broker like TradeKing can help traders reduce their overall costs due to its low commission rates.

Abiding by the Rules when Getting Started with Day Trading

As you can see, it can be easy to lose track of how many day trades you've completed if you do not fully understand how to count them correctly. If you are not able to maintain the minimum equity level of $25,000 you need to pay strict attention to the number of transactions you make. Luckily if your account is with TradeKing, you will have access to experienced brokers that can help you navigate these sometimes confusing rules. Not only that, TradeKing's online platform will give you a warning message when making your third day trade. These features in addition to TradeKing's thriving trade community and extensive Education Center are great reasons to open an account.

Get Started With TradeKing

TradeKing is an online broker with a simple mission: we want to help investors like you become smarter, more empowered stock and options traders. At TradeKing we offer the same fair and simple price to all our clients - just $4.95 per trade, plus 65 cents per option contract. You'll trade at that price, no matter how often you trade, or how big or small your account may be.

In August 2007, SmartMoney Magazine rated TradeKing the best discount broker for the second year running. The SmartMoney survey was based on criteria for commissions, interest rates, mutual funds, investment products, trading tools, banking amenities, research and customer service.

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