Day Trading on Margin
Day trading on margin – using borrowed money to leverage one’s trading results – is a speculative practice that can be dangerous. Margin trading is not for novice traders, who have yet to establish effective strategies and risk management practices.
Margin trading works to amplify gains and losses. Indeed, the central purpose is to augment trading profits, but trading should always be considered from a “defensive” perspective, as playing good defense is what will keep you in the game over the long-run.
Day traders often make multiple transactions per day to profit off relatively small fluctuations in the market traded. Therefore, if you go on a cold streak where the market moves against you, trading with leverage can wipe out a substantive fraction of your trading account in short order.
For day traders, the amount you can borrow in your brokerage account is different for swing or position traders who have longer holding periods. Day traders typically can borrow up to 4x the amount of cash they’ve deposited into their account beyond the minimum equity requirement based on standard Regulation T (“Reg-T”) rules. For those who hold positions overnight it is generally limited to 2x. Naturally, you will want to check with your broker and the laws within your particular jurisdiction. (More on this below.)
But the idea behind allowing day traders to borrow more heavily than longer-term traders is because the smaller holding periods are less likely to result in a security moving in a material way. Therefore, the expected drawdown or potential loss on any given position is less. This carries the stipulation that positions must be closed overnight. Any leverage beyond that permitted for overnight trading will result in a margin call and automatic liquidation by your broker.
Pattern Day Traders vs Non-Pattern
Note that the rules and regulations can be very different between the types of day traders. There are two main distinctions. Some will be labeled “pattern day traders” while others will be considered “non-pattern day traders”.
Pattern day traders are classified as those who execute four or more day trades within five business days, given that one or more of the following is fulfilled:
a) The number of day trades is more than 6% of the total trades in the margin account during the same five-day period. Therefore, if an individual executes four day trades within one week and executes fewer than 67 other types of trades (to satisfy the 6% rule), he or she will be classified as a pattern day trader.
b) The individual engages in two unmet day trade calls within 90 days (i.e., goes over the buying power limitation more than once within 90 days).
c) The brokerage firm you trade with – through its own discretion – can also designate you as a pattern day trader if it has reason to believe you should be classified as one. This can happen in cases where, for example, it provided day trading training to you before an account was opened in your name.
More frequently asked questions about this matter can be found on the official FINRA website.
If none of the above criteria are met, then a trader will receive a non-pattern day trader classification. Moreover, if a pattern day trader does not execute any day trades for 60 consecutive days, then his or her account will be altered to a non-pattern day trader account automatically.
Why “Pattern” vs. “Non-Pattern” Matters
The answer comes down to margin requirements. For pattern day traders, the margin requirements are materially higher. That is, pattern day traders must put up a higher minimum equity requirement that non-pattern day traders.
Pattern day traders, must hit a minimum of $25,000 or 25% of the total market value of securities in their account, whichever is greater. Non-pattern day traders, on the other hand, are generally provided a minimum equity requirement of $2,000. If an account were to fall below its minimum equity requirement, trading would be suspended until the stipulated amount is fulfilled again.
As abovementioned, pattern day traders can purchase up to 4x the amount in excess of the $25,000 minimum equity requirement.
For example, if one has an account with $40,000 deposited, this amount is $15,000 in excess of the requirement ($40,000 – $25,000). Applying the 4x rule, this means the account can trade up to $60,000 (i.e., $15,000 multiplied by four) worth of securities.
The broker will issue a margin call if this amount is exceeded, with five business days given to meet the call – i.e., reducing the amount of securities owned to a satisfactory level. This is often done automatically by the broker, which will liquidate positions to get the account back within an acceptable level. If not, in the intervening period – between the issuance of the call and meeting it – day trading buying power will be restricted to two times the maintenance margin excess. If the trader does not meet the margin call during the five business days allotted, trading will be permitted on a cash-only basis. This can be reversed once the margin call is met.
Margin calls will be sent out so long as buying power has been breached irrespective of whether positions were sold that same day. For example, if a trader has $25,000 above his maintenance margin amount and decides to buy $110,000 of a particular stock (above the 4x stipulation), even if he buys and sells that position within the same market hours he will receive a margin warning or call either immediately or the next business day.
Please note that these rules are not set in stone and can vary by the broker you trade with and/or the jurisdiction you are trading in. Brokers often lay out their own rules and have the latitude to modify and adopt rules of their own to protect their personal business interests. This can mean broadening the rules regarding what a pattern day trader is, enforcing certain minimum equity requirements, or restraining the buying power of certain accounts. You must always check with your broker before signing up to understand what exactly is required and what specific rules might apply.
Having Realistic Expectations
If you choose to day trade on margin, understanding the risks is imperative. Small fluctuations in the price of your owned securities can lead to outsized moves in the price of your portfolio.
Using margin may allow you to trade with money you don’t currently have and help with issues of undercapitalization that many traders have. However, this of course isn’t going to help you make more money if you don’t have a viable trading strategy or effective risk management practices.
Trading is not a realistic way to get rich quickly. Making a living off trading requires having a capital base of sufficient size. Nobody will be able to make a living off trading with just a few thousand dollars. To back out how much of a capital base you’ll need to make a living day trading, you need to start with how much income you require from trading and divide that by your expected percentage return each year.
For instance, the S&P 500 is expected to return about 7% per year in nominal terms going forward. Most hedge funds, which employ very smart and sophisticated investors, fail to reach this annualized return. But obtaining this mark can 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. There will be fluctuations, sometimes wild ones, depending on your strategy and risk management. There is no such thing as a safe 7% return, and if you day trade you probably follow volatile markets, such as equities, commodities, and/or currencies.
Nonetheless, when properly utilized, margin can be a good thing and help push one’s expected returns up to a risk level one is comfortable with. Margin trading can also be safer than standard cash-only trading when it incentivizes a trader to take a low- to moderate-risk strategy – knowing leverage will help increase whatever gains are made – rather than a high-risk strategy to compensate, such as taking large concentrated positions in high-risk securities.
Day trading on margin can be risky, and should not be tried by beginning traders. However, for experienced traders with profitable trading strategies and systems in place, using low to moderate amounts of leverage can actually be a less risky endeavor than using no leverage and chasing returns with suboptimal trading strategies.