Pros and cons of day trading with less than $25k
If you are looking at day trading stocks, then at some point you might have wondered what it is like to day trade with a few thousand dollars. For the most part, equity traders do not have the luxury of day trading with small funds and neither can be bet too much of leveraging their funds.
As a rule, the U.S. Securities and Exchange commission (SEC) underlines that U.S. day traders are required to maintain a minimum balance of $25,000 in the day trading account. In order to circumvent this limitation, traders often look to the futures or forex markets.
Certainly, the requirements are much less and the fact that you can leverage your trading account is a big plus point. This one of the reasons why many traders, especially those in the United States tend to look into other markets such as forex and futures.
When it comes to trading stocks, day traders at hit by various rules and regulations and also tax implications that come alongside day trading rules.
If you are wondering why these are the requirements, then it comes due to the fact that there is a rule called the pattern day trading rule.
What is the pattern day trading rule?
The Pattern day trading rule is a regulation by the SEC. Under this rule, a trader who executes four or more trades during a five day period is designated as a pattern day trader. This includes buying and selling the same security within the day in a margin account.
The securities involved are stocks, options and short sales which might occur during the same day. There is however an exemption. Positions that are held open overnight but sold before new securities are bought and sold are exempt from the pattern day trading rule.
When a trader is classified as a pattern day trader, they are automatically obligated to hold $25,000 in their day trading account. When their equity falls below this threshold, they are prohibited from making any more traders until the balance is replenished.
During a margin call, a pattern day trader has five business days to bring their equity back to the threshold. During this period, trading is restricted in the account. Failure to fulfil the margin call results in the day trading account being banned for a period o 90-days.
While these are the general rules, individual brokerage firms tend to implement their own rules which are much more stringent.
Pattern day traders are able to make use of a leverage of 2:1. This can be further increased when a trader uses a margin account to trade futures for example.
If you look back in history, the pattern day trading rule was established only recently. Some call it as a way for financial regulators to catch up to technology. In the 70’s, where trading was mostly done in the trading pits, a trader was required to have just $2000 in capital.
This was because not many retail traders were able to get licenses to trade on the trading pit. However, with the advent of electronic trading, everyday households were suddenly able to gain access to the financial markets and make money easily.
Why was the pattern day trading rule enforced?
Day traders might get frustrated by the strict rules that come with pattern day trading. However, there is logic behind this strict rule.
Day trading or speculation gained prominence during the 90’s. Due to the stock market rally, just about everyone wanted to get their piece of the pie. This led to many households opening up a trading account and trade on leverage or margin.
Following this bout of popularity with day trading, the SEC and the FINRA moved to create and implement the pattern day trading rule. The rule was implemented in 2001. According to the SEC< the pattern day trading rule is described as below:
“any customer who executes four or more day trades within five business days, provided that the number of day trades represents more than six percent of the customer’s total trades in the margin account for that same five day business period.”
Thus, when a trader is classified as a pattern day trader, they must maintain a minimum balance of $25,000 in their trading account at all times. This is done in order to prevent investors from being over leveraged.
When you are over leveraged, it can be risky when you face losses. The stock markets are risky and when a trader is over leveraged, it can lead to losses more than the capital that they have risked. This in turn tends to put undue pressure on the brokerages, who are basically leading you the money to trade on margin.
To prevent a snowball effect, the pattern day trader rule was established so that traders are more responsible, while at the same time ensuring that traders who trade on margin need to be responsible for their losses.
However, some believe that these restrictions limit the trader. Many traders feel that the pattern day trading goes against the spirit of the free markets. Due to the restrictions, pattern day traders tend to look for other markets will less regulation.
Thus, traders look to the more risky and highly leveraged markets such as currencies and futures which are more volatile and risky compared to stocks. With the pattern day trading restrictions, the trader is limited and prevents him from diversifying their portfolio in order to balance out the risks.
Still, regardless of which way you approach this topic, pattern day trading rule is quite controversial for many U.S. stock traders.
Day trading without margin
Traders have the choice to trade without margin as well. In this case, traders do not make use of the leverage, but rely only on their account balance. For example, if you had $30,000 and you do not want to make use of margin, then $30,000 worth of shares is all that you can buy.
This is also known as a cash account. One of the benefits of using a cash account is that the pattern day trader rule does not apply. This happens because you are not leveraging your account, or in other words, not trading on margin.
But there are of course some disadvantages to trading without margin. For one, traders need to be well capitalized if they want to day trader. You are limited to the number of shares you can buy or sell based on your account balance.
If you have a higher account balance, chances are that you are able to transact more. But this also increases the risks of losses.
Leverage, works both ways. While it can increase your chances of maximizing your profits, it can also increase the risks that your account will take in case of making a wrong trading judgement. The SEC and other financial regulators have in recent times moved to curb the use of leverage.
In the forex markets for example, just a few years ago, brokers were able to offer insane leverage such as 1:1000. This meant that by depositing just $1000, a trader would be able to trade 1000 times their capital.
This leads traders to take on undue risk which could lead to their capital being wiped out. As a result, regulators from around the world moved to restrict the use of leverage in a bid to prevent the individual trader from taking on more risk in an attempt to reap higher rewards.
Can you day trade with a cash account?
A cash account is basically a term that defines a trader who is not trading on margin. There are of course quite a few limitations when trading with a cash account.
Because you are not using margin, your risk is solely borne by you.
Some might think that this is a good way to trader. After all, when you trade with a cash account the pattern day trading rule does not apply to you anymore. But the question that comes to mind is whether you can day trade with a cash account?
The answer is yes and no.
If you want to day trade, meaning that you will transact in shares few times a day, then you need to be well capitalized. Because you are not using any margin or leverage, this puts only your capital at risk.
So, obviously you can see the difference between a trader who has $25,000 compared to a trader who has $250,000 in their trading account. When your trading capital is higher, there is a higher chance and flexibility for you to pick and choose the securities that you want to trade.
However, the options market can provide a middle ground. Because trading options is a lot cheaper compared to trading stocks outright, you can manage to trade options with a cash account and make money while at it as well.
However, you won’t be able to trade too many option contracts on a cash account because this is once again limited by the amount of capital that you want to risk.
So, to answer the question of whether you can day trade with a cash account, the answer is yes. The only thing to bear in mind is that you need to be well capitalized in order to be successful with day trading.
But the truth is that not many traders can afford to risk that amount of money into speculating in the financial markets.
Leverage is something that is often used in every day life. For example, when you take out a mortgage, you are basically leveraging your down payment or the initial amount that you pay for the home.
The bank that gives you the mortgage, leverages you up so that you are able to purchase that home of your dreams. Even companies make use of leverage through various financial products in order to raise the required cash flow.
Therefore, many believe the leverage is an essential aspect of the financial markets. But with leverage, there are also big risks that come along. While one can make use of leverage, there are checks and balances in place in order to prevent an investor from being over leveraged.
What are the markets that you can trade on margin?
While there are apparent restrictions on the way you can trade stocks in the U.S. and in most other countries, there are some markets that allow you to trade on margin. These are obviously the preferred choice of markets for many traders.
The futures market is one such market that allows traders to trade on margin or to trade in leverage. The futures are merely derivative markets which track the underlying securities. Typically, futures brokerage accounts allow some flexibility when it comes to trading on leverage.
However, the choice of securities available in the futures markets are mostly geared up towards commodities and a few financial products. If you prefer to stock with equities, then the futures market isn’t quite right.
Traders can also choose to trade the forex markets where leverage offered is quite high. But again,
trading currencies is not everyone’s cup of tea and requires a different approach to day trading compared to stocks.
There are of course CFD’s, also known as contract for differences. These are also derivative products which tracks the underlying security’s prices. With CFD’s, traders can trade on margin, but the downside being that when you transact in CFD’s you don’t actually own the underlying security.
The spreads are also a bit high for stock CFD’s compared to trading actual stocks as well. If you are a trader who prefers to day trade equities and the fact that not owning the underlying shares does not bother you, then stock CFD’s are ideal as it allows you to trade on margin and circumvent the pattern day trading rule.
But bear in mind that the costs associated with trading stock CFD’s are a bit higher compared to trading regular stocks.
In conclusion, the pattern day trading rule is set in place in order to prevent day traders from being over leveraged in the markets. The restrictions can at times be frustrating for traders and as some argue, it can push a trader to trade the more risky markets.
There are some pros and cons in regards to trading with a cash account as well. However, this largely depends on how well capitalized you are and whether you are able to risk huge amounts towards financial speculation.