Day traders have a lot of leeway in how they trade. They can develop their own strategies, choose how much to risk on any trade, and even set their own working hours.
But there are some rules that day traders need to follow. These rules are designed to make sure that day traders and brokerage firms are on the same page, protect the market during periods of volatility, and prevent traders from getting out of paying taxes.
In this guide, we’ll take a look at some of the key day trading rules that every trader should know.
The Importance of Understanding Day Trading Rules
It’s important to understand day trading rules because there are consequences for violating or triggering them. Depending on which rule is violated, day traders may face limitations on how they can trade or move money around their brokerage account. Triggering certain tax-related rules could end up forcing a trader to pay more in capital gains taxes at the end of the year.
In addition, some rules limit trading across the entire market when they’re triggered. Traders need to understand these rules so that they can plan around them and not end up stuck in an open position.
Day Trading Rules
Let’s take a closer look at some of the key rules that day traders need to know.
Pattern Day Trader Rule
The Pattern Day Trader (PDT) rule applies when you make four or more day trades in a five-day period in a margin account (traders are limited to three “round trip” trades). The number of day trades must be at least 6% of the total number of trades in the five-day period for the rule to apply.
Once you trigger the PDT rule, you will be flagged as a pattern day trader. From that point on, you must have at least $25,000 in cash and securities in your account in order to make day trades. If your balance falls below $25,000, you won’t be able to close a trade until at least the day after it’s opened. You’ll need to contact your brokerage if your trading style changes and you want to be unflagged as a pattern day trader.
Regulation T (Unsettled Funds)
Regulation T is a rule that stipulates that anytime an investor buys a stock in a brokerage cash account, the stock purchase must be paid for in full. This rule matters to day traders who use a cash account because they can run afoul of it if they’re not careful.
When you sell a stock, the proceeds from the sale typically take two days to settle. In the meantime, you can use the unsettled funds from the sale to buy more stocks. However, you can violate Regulation T if you use unsettled funds to open a position and then close that position before the funds from the first sale are settled.
This incurs what is known as a good faith violation. One good faith violation usually results in a warning, but no actions on the part of your broker. After two or three good faith violations in a 12-month period, you will be restricted to using only settled funds to trade for a period of 90 days.
Uptick Rule for Short Sellers
The uptick rule is an SEC rule that applies when short selling a stock whose price has dropped 10% or more from the previous day’s close. It specifies that in order for a trader to short a stock that has dropped by 10% or more, the prior tick must be positive. In essence, you cannot short a distressed stock while it is actively going down.
The uptick rule is designed to prevent short sellers from driving down the price of a stock in an out-of-control way. It doesn’t prevent most legitimate short selling since only one upward tick is required for a short position to be opened.
The wash-sale rule is an IRS rule designed to prevent traders from claiming artificially inflated capital losses. It applies when you sell a stock for a loss and then buy back the same stock (or a substantially similar security) within 30 days. The wash-sale rule also applies for 30 days before you sell a stock for a loss. So, the total window over which the rule applies is 61 days.
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If you trigger the wash-sale rule, you won’t be able to claim a capital loss on the original sale when filing your taxes. There are no tax or trading penalties for triggering the wash sale rule, and many day traders trigger this rule somewhat frequently.
Day traders and active traders should also be aware of how the IRS classifies capital gains. Profits from trades that are open for less than one year are classified as short-term capital gains, while profits from trades that are open for longer than one year are classified as long-term capital gains. Losses are also classified as short-term or long-term.
Short-term capital gains are taxed as ordinary income, but special tax brackets apply to long-term capital gains. For most traders, long-term capital gains are taxed at lower rates than short-term gains.
Day Trading Best Practices
It’s important to be aware of the day trading rules above, but they shouldn’t unduly influence your trading. Here are some personal trading rules you can follow to increase your chances of success while trading. While these aren’t actual regulations, they are essential best practices for traders who want to sustain a long career.
Cut Losses Quickly
When day trading, it’s extremely important to cut losses sooner rather than later. It’s better to preserve capital for a successful trade than to lose more money on a trade that isn’t working out. You may consider setting a stop loss when entering each trade to limit the amount you can lose if a trade goes against you.
Don’t Trade with Money You Can’t Afford to Lose
Day trading is inherently risky, and there’s no guarantee that any one trade will be successful – or that you’ll make money overall. Never trade with money you can’t afford to lose.
Focus on Favorable Risk/Reward Trades
A good way to approach trades is to think about the maximum amount at risk (which is easy to calculate if you use a stop loss) and your profit target for the trade. With those two numbers, you can calculate the risk/reward ratio for any trade. In general, successful day traders look for trades with a risk/reward ratio of 1:3 or better.
Always Have a Game Plan
No matter what your day trading style is, it’s critical that you approach every trade with a plan in mind. Every day trader should have a strategy that you follow when making trades. Day trading without a strategy is more like gambling than smart trading.
Conclusion: Day Trading Rules
Day traders need to be aware of rules that govern specific types of trading activity, especially since these rules can have consequences for how you can trade or how much you’ll pay in taxes. In addition to the trading rules set out by regulators, every trader should have their own set of best practices to guide their trading.