Many investors choose a buy-and-hold strategy for the stocks they keep in their portfolios. Then there are those who buy and sell a stock, sometimes within just a few hours, in an effort to profit from a fluctuating stock price. These individuals are known as day traders. They rose to prominence in the 1990s as the development of inexpensive desktop computers and software programs made online trading easier.
During that time, day trading held the promise of big gains—until it toppled with the dot-com bubble burst. Wall Street reforms soon followed, including greater guardrails for day trading and laws like the Sarbanes-Oxley Act to better protect investors.
But the practice of day trading remains, and is most common in the stock and foreign exchange markets. While the practice is legal, investors who trade the same securities often in a single day are potentially flagged as “pattern day traders" (PDT), which requires adherence to Financial Industry Regulatory Authority (FINRA) requirements. Triggering the rule can lead to the locking of your account and financial risks that most individual investors can’t tolerate.
Because day trading can be complex and risky, the Securities and Exchange Commission has issued a warning about the practice.
Can you buy and sell a stock on the same day?
Retail investors can buy and sell stock on the same day—as long as they don’t break FINRA’s PDT rule, adopted to discourage excessive trading. That rule identifies a pattern day trader as “any customer who executes four or more day trades within five business days, provided that the number of day trades represents more than 6% of the customer’s total trades in the margin account for that same five business day period.” Once tagged, they are restricted by their broker from conducting trades. And to continue trading, they must bolster their margin account, a brokerage account used as collateral so the broker-dealer can lend the investor cash to purchase securities.
But the process is not always so cut and dry: broker-dealers may impose stricter conditions, including a higher minimum equity requirement. And the PDT designation may not be so easy to shake once acquired.
By comparison, those who aren’t considered pattern day traders under FINRA’s classification can execute three day trades within five trading days. Some frequent traders bypass the day-trading rule altogether by buying one day and selling the next, which is not considered day trading.
Frequent traders who choose this type of work should understand settlement periods. When someone sells a stock, they don’t receive the cash in their account right away. Most stock trades settle two business days after the order executes. (Traders call this T+2, or the trade date plus two business days). An investor can trade on margin, but they’ll pay interest on those borrowed funds during the settlement period. Some brokerages impose their own restrictions on frequent trading, such as limiting trades on new accounts or accounts that don’t contain a certain amount of cash.
For those taking on day trading, here’s an overview of some key requirements:
Establish a day-trading account. Day traders need a margin account containing at least $25,000 to qualify as a day trader. The account minimum net worth must stay above $25,000 or expect a margin call from their broker. A margin call happens when the value of the margin account falls below the required amount, and is a broker’s demand for the deposit of money or securities to bring it up to the minimum value, or maintenance margin, within five business days.
Meet margin requirements. The $25,000 margin requirement can be met by combining cash and securities—but must be in a trader’s account prior to their conducting day trades. Day traders also cannot trade more than their “day-trading buying power,” which FINRA defines as up to four times the maintenance margin excess as of the close of business. To calculate this amount, a trader can take the amount by which the equity in the margin account exceeds the required margin and multiply it by four. So, if there’s $30,000 in the account and that’s $5,000 more than the $25,000 minimum requirement, then the trader can buy up to $20,000 in securities.
Lift trading restrictions. An experienced investor can ask their brokerage to lift restrictions from their account. A brokerage may have their own threshold, such as a trader’s financial standing, the age of their account, or the number of trades they have already executed. Some investors ask to lift the restrictions on their accounts even if they don’t intend to day trade so they can act swiftly on a stock without their account getting restricted.
What are the risks and implications of day trading?
Day trading can be appealing because it offers an opportunity to take advantage of quick price fluctuations in the stock market, betting on short-term stock prices. On the flip side of this speculative endeavor, is risk.
Frequent trading can be expensive, because every transaction may incur broker fees. Additionally, frequent trades can incur short-term capital gains taxes, which are taxed at the same rate as ordinary income—not at the lower, long-term capital gains rate. If an investor holds a stock longer than a year, the maximum capital gains tax rate is 15% or 20%, depending on the investor’s taxable income and filing status. The short-term capital gains tax is whatever a person’s ordinary income tax rate is, in other words, up to 37%, according to the IRS.
What is the two-hour-a-day trading plan?
Some people want to trade actively but either have no interest in following the market the entire day or simply don’t have time. So, they employ a two-hour-a-day stock trading strategy. This involves making transactions for two hours—generally during the first and last hours of the trading day—when volume tends to jump.
The volume tends to be higher when the market opens because investors may have used their evenings to research and place trade orders for the next day, which floods the market with programmed trades. Also, day traders set their positions for the day early on. And mutual funds, hedge funds, and other high-volume traders execute orders in the morning.
Trading volume tends to cluster around the morning and evening, but institutional investors, especially, trade later in the day. For instance, some money managers sell stocks in packages before the market closes to get orders filled before being exposed to losses in after-hours trading. Plus, retail investors who want to avoid being flagged as pattern day traders sometimes buy stocks at the end of the day, knowing that they can sell them the next day and stay within FINRA’s parameters.
Investors who successfully employ the two-hour-a-day plan often have a solid understanding of how the volume of trades works in the market (volume is a measure of how many shares are traded within a period and can indicate the mood and strength of the market). A stock trading at high volume shows rising interest and strength in the market, while low volume indicates less interest in a stock. Two-hour-a-day traders look at the volatility in the first and last hours, where they can snap up a stock in a dip or sell a stock that spikes.
The bottom line
Taking advantage of fluctuations in the market is an appealing idea for many investors, and access to apps and online brokerages has made day trading an increasingly more accessible venture. FINRA regulates frequent day trading by restricting the accounts of retail investors who exceed four day trades in five days, while the SEC warns day traders there is risk and expense in frequent trades. Still, there are methods of trading—such as buying one day and selling the next—which allow individual investors to make trades without being subject to the rules that apply to those classified as pattern day traders. Those who make frequent trades should understand there are strict requirements and financial implications of day trading.