Excited to make money through day trading?
You’ve probably researched the essential stuff you are required to have before day trading – but hold your horses!
Before jumping in, you must know the day trading rules first – or more specifically, day trading rules for options.
First, let’s review the basic terminologies. We’ll then go over the rules of day trading, and then some essential tips and “unwritten” option trading rules that you should know.
The Basic Terms You Need To Know
Before you start day trading, you should know the following terms and their definitions by heart:
Day Trading. You should already know this! But as a reminder, day trading refers to buying and selling a security within the same day. The Financial Industry Regulatory Authority (FINRA) emphasizes that only purchasing a security (without selling) within a day is not considered a day trade.
Pattern Day Trading. Pattern day trading is defined by FINRA as trading four or more times in five business days. According to FINRA, the minimum equity requirement for pattern day traders (which must be maintained) is $25,000. When you reach this amount, you can trade as often as you like. If your account doesn’t meet this minimum, you will not be allowed to trade unless you add some money or securities to reach $25,000.
So how does pattern day trading differ from standard day trading, you may ask? Aside from the minimum equity requirement of $25,000, a distinct difference of pattern day trading from standard day trading is access to margin. Pattern day traders’ Day Trading Buying Power for stocks are four times the normal margin value.
Increased leverage resulting from increased access to margin can be an advantage for pattern day traders—but this will really only be an advantage when used wisely.
Day Trading Buying Power. Day Trading Buying Power (or more commonly known as DTBP) is the available money you have for placing trades within a trading day. Note that this only applies to accounts classified under Pattern Day Trading.
Basic Rules and Regulations: All You Need to Know
Now that we’ve got the basic terms and definitions settled, let’s move on to the rules you should abide by when day trading.
You must meet the minimum requirement of $25,000 once you are labeled a Pattern Day Trader.
Only traders with $25,000 in their accounts are allowed to trade – and maintenance is a must.
If you do day trade without meeting the minimum, you will be limited to closing transactions only and you will have to let go of your margin advantages. You can only go back to day trading once you meet one or more of the following requirements: bringing up your equity back to $25,000, fulfilling all your margin debits, or not participating in day trading for 90 days.
You might be asking – once I deposit funds to meet the minimum requirement, can I withdraw them immediately after? Sorry, but no. The funds that you deposited to meet the minimum should be in your account for at least two business days.
Your $25,000 (and above) must be stored in a brokerage account.
You can have a mix of cash and securities – but it must be in a brokerage account. You cannot store your equity in the bank. Why? Well, it doesn’t really make sense to “trade” when your equity is in the bank, because all the risks associated with day trading only occurs in brokerage accounts.
If you’re worried about risk, remember that you are protected by the Securities Investor Protection Corporation (SIPC) for up to $500,000 for each securities account.
Cross-guaranteeing is not allowed.
Day trading accounts are considered independent accounts, and thus cannot participate in cross-guaranteeing (cross-guaranteeing occurs when a firm provides a guarantee to a related company).
On a related note, using loans to purchase securities and fund your account (e.g. asking for your firm to cover your profits or losses) is also strictly prohibited.
You cannot day trade with cash accounts in general.
Related to this is the Federal Reserve’s free riding prohibition (under Regulation T), since you can only day trade with cash accounts as long as you comply with that rule.
Free riding is when you trade first before paying (or using unsettled funds). If violated, your account will be frozen by your firm for 90 days. Also note that even if you do not use leverage, this rule should still be followed.
You can only trade up to your day trading buying power.
You will get a day trading margin call (issued by your broker) if you trade beyond your DTBP. Once that is issued, you must deposit funds to your account within five business days to comply with the day trading margin call.
Within those five days, your DTBP is limited to only two times the normal margin value (in contrast to the usual DTBP for pattern day traders, which is four times the standard margin value). If you fail to meet this deadline, you can only trade on a cash basis for 90 days (or when you satisfy the call).
The Unwritten Day Trading Rules: Essential Tips for Beginners
Now that you know the basic official day trading rules, it’s time to move on to the unwritten tricks of the trade. Following these tips can help you trade better and smarter:
Don’t rush into buying at the opening bell. One of the most essential characteristics of day traders is discipline, and you must resist immediately buying options, especially since they have greater risks attached to them. Many traders panic at the opening bell—don’t emulate them! Wait a little while to let the market clear, analyze trends, and determine which stocks or options to trade for the day.
When buying options, choose those with as little time value as possible. Since one of the disadvantages of day trading is the loss of time value, deal with options with little time value – meaning options that are highly liquid, in-the-money, and near-month.
Have a plan and stick to it. Following a plan can help you minimize your risks and losses in day trading. The plan should include entry, exit, and ‘escape’ prices for your stocks or options. This could also help you formulate your trading strategy in the long run, as you’ll get to know which steps work and which don’t.
Determine the number of stocks to trade. For beginners, it is highly advisable to stick to one or two stocks to limit risk and losses. Once you’re confident with your trading strategy (which could take a while), you can gradually increase this number.
Keep and maintain a trading journal. Many successful investors and traders abide by this rule. This can help you learn from your costly mistakes, and avoid making them again in the future. Check out this video for more detail on how to keep a trading journal:
Don’t fall for shady tips and scams. There’s a reason why people still say “if it’s too good to be true, then it probably is.” It can apply to day trading as well – if someone’s promising you a huge amount of money through day trading, don’t go for it. This includes tips from people you don’t trust, as this could lead to costly decisions.
Set the time and money for day trading. Most day traders will tell you that day trading is time-consuming, and requires a huge capital. You should set aside some time for it, and make sure that you have enough money (don’t use all of it!) to start trading and maintain accounts.
The Secret to Successful Day Trading
It takes a lot of time, money, and discipline to be successful in day trading. Some of the pros still make mistakes and incur losses every now and then.
The important thing is to take note of them, and make sure you don’t make them again in the future. These will then improve your trading strategy, and make you an overall better and smarter investor.
Editor's Note: Now that you are equipped with the rules of trading, you can take the next step. Get trade alerts from the experts! With the alerts you get, there is even less of a guessing game and you can increase the odds of success.