Even though day traders are considered self-employed, they are still subject to regulations. Some day traders must fulfill certain financial securities to back up their trading habits—such as pattern day traders. But why do pattern day traders need $25,000?
Pattern day traders need to have at least $25,000 in their brokerage accounts to minimize risks that these highly-active traders may bring upon their firms. If the account dips below $25,000, the pattern day trader must withhold from completing any trades until the account returns to $25,000.
The following article will explain in more detail the difference between a pattern day trader and a standard day trader. Additionally, we will look at why a pattern day trader must have $25,000 in their combined brokerage accounts and the consequences if they fail to do so.
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Pattern Day Traders and Standard Day Traders: What’s the Difference?
There are two main types of day traders: the pattern day trader and the standard day trader. The standard day trader is, as you might imagine, the average person who trades a few stocks daily. These are generally not professional day traders; they are closer to hobby traders than anything else.
Pattern day traders, on the other hand, are usually considered professional traders—at least part-time. A pattern day trader is classified as someone that makes four or more day trades (a buy and sell exchange) within five business days, and these transactions count for more than six percent of all account activity. A full or part-time trader will quickly fulfill this quota, making them at least semi-serious about day trading.
Here’s an example of how you would qualify as a pattern day trader:
You buy stock 20 times in one week. You sell the same stock in ten different transactions. You only make one other investment that week: a single stock for a different company. That means less than 1% of your transactions were standard investments, 99.5% of them were risky trades. This ratio would make you a day trader.
If you’re wondering who would be keeping track of your trades and how they would know if the deals you were making counted for 6% or more of your weekly activity, you can look to computers. The first level of tracking your transactions is fully monitored by computers. When your account hits more than four trades in one week, your account will be flagged for your brokerage to investigate.
What Is a Pattern Day Trader?
Pattern day traders are required by the Financial Industry Regulatory Authority (FINRA) rules to have a certain amount of money in a “margin account.” To understand a margin account, think of the function of a margin on a piece of paper. It is there to provide a little flexibility—if you write into the margin, it’s not a big deal. There’s a little bit of wiggle room for you to work with.
A margin account functions in essentially the same way. It allows a little bit of wiggle room for the trader. A pattern day trader must have $25,000 in this margin account because they often take place in risky transactions that could easily amount to a loss of funds for the investors. This requirement is called the Pattern Day Trader Rule.
What Will Happen if You Don’t Have $25,000 in Your Brokerage Account?
To trade stocks in the first place, you need to set up a brokerage account. This account is where you or your clients will deposit their money for you to move about purchasing and selling stocks as you see fit.
As a pattern day trader, you are required to have at least $25,000 in this account of your capital. This requirement ensures that you can cover your client’s potential losses if you short sell a stock.
It’s important to note that when it comes to pattern day trading, “If you do not have $25,000 in your brokerage account before any day-trading activities, you will not be permitted to day trade. The money must be in your account before you make any day trades, and you must maintain a minimum balance of $25,000 in your brokerage account at all times while day trading.”
Your account will stay inactive for as long as it takes until your balance once again reaches $25,000. During this time, you won’t be able to buy, sell, or short stock on behalf of yourself or any of your clients, which can greatly inhibit your broker-client relationship. It is in your best interest to keep at least $25,000 in your brokerage account at all times.
Ways to Trade if You Don’t Have $25,000
If you don’t have $25,000 in your brokerage account, or anywhere else for that matter, there are still ways that you can trade.
Keep the Peace as a Standard Day Trader
If you don’t have $25,000, but you’d like to start day trading, you need to ensure you stay below the Financial Industry Regulatory Authority rules. Trade less than four times per week, and if you do trade more, then make sure your investments and sales are not rapid-fire transactions.
As long as the risky buy-and-sell-in-quick-succession trades don’t count for more than 5% of your transactions for the week, you should be able to continue as a standard day trader living under the radar.
Take Part in a Day Trading Firm
A day trading firm is much like a real estate agency. You get to take advantage of their resources while contributing something of your own.
When you sign up with a day trading firm, you’ll invest a small amount of your capital into a brokerage account to get started. The firm will top-up your account, giving you more freedom to work with. If you start to slip and cost the firm any money, they will simply cut you off and keep your original investment.
Aim Your Trades Beyond the US Borders
The minimum trade rules that the FINRA has put in place are only applicable in the USA. While many countries have similar rules, there are many regions where you don’t need to abide by the Pattern Day Trading Rule.
In order to take part in foreign day trading, a foreign brokerage account is required. Do your research and look into which foreign markets may be easiest to understand and which won’t punish you for having less than $25,000 in your brokerage accounts.
Become a Swing Trader
A swing trader is another type of trader who is less active with the day-to-day trades. If your goal is not to be a professional trader but to obtain extra income and dip your toes in the trading waters, starting as a swing trader could be the perfect way to do it.
Whereas a day trader works in 24-hour cycles, a swing trader works in weeks. You still have to watch the markets, keeping an eye out for upward and downward trends, timing your investments and sales perfectly, but there’s less pressure than with the daily uphill struggle of a Pattern Day Trader. Your transactions are also spread out enough that you don’t need to worry about the $25,000 in equity.
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Conclusion
The best way to think of the $25,000 required to be a pattern day trader is as collateral. Federal institutions set these standards to protect people that trust traders with their cash. It’s not that traders are inherently untrustworthy, but many traders in earlier years made trades so fast that their accounts couldn’t update in time to reflect the changes. Once the account was updated at the end of the day, the trouble was clear.
Now, pattern day traders are required to hold $25,000 in their brokerage accounts to compensate for the business’s high risk.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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