Even trading veterans aren’t immune to the stock market’s pitfalls. But investing beginners must also learn rules and risks associated with trading, some of which happen to revolve around day trading. Here’s the rundown, including how day trading works, what constitutes a pattern day trader and the day trading risks you ought to know.
- Day trading means buying and selling a stock within a single day.
- A lot of brokers have their own rules on day trading, but there are widespread rules over being a pattern day trader or making margin calls.
- Day trading risks are real. Only a small percentage of day traders make money at all, and they’re usually people who spend full-time hours watching market swings.
- Since February’s major crash, the stock market has been particularly volatile. This only compounds the risks of day trading further.
- You can learn more about alternative investing strategies here.
What is day trading?
Day trading is the act of buying and selling a stock within the same day. This means trading in hours, minutes or even seconds.
A small percentage of investors use day trading as their primary technique, and do so on practically a full-time basis. This means consistently watching stocks rise and fall throughout the day, and getting out once you’re in the green — even marginally. Successful day traders argue that a lot of these quick, small wins add up over time.
Other day traders, however, are average investors with access to mobile or on-demand trading platforms. They might check their phone a few times a day and buy or sell depending on how the stock is performing at that particular time.
In the past, we’ve shared tips for investors to better understand how, who and what to invest their money in. This includes choosing an investing strategy, reviewing the prospectus for a new IPO and reading earnings reports every quarter. But day traders don’t mind these quite so much. Because whether it’s amateurs or professionals doing the day trading, it’s about quick fluctuations — not the long-term picture.
Rules of day trading
Different platforms have different rules about day trading. Whatever rules a stock market trading platform has, it’s not about any moral wrongdoing. It’s about the heightened risks associated with this investment strategy.
Commonly, you’ll see rules against:
- Pattern day traders: A pattern day trader (PDT) is someone who completes at least four day trades within a single week. These trades must take place on a margin account (AKA borrowed money) and make up 6% or more of the trader’s total activity. Many brokers will institute account limitations for PDTs. The investor’s margin account balance must be at least $25,000, or else they risk further scrutiny.
- Margin calls: The Financial Industry Regulatory Authority (FINRA) says day traders must meet a maintenance margin requirement of 25%. This means you must withhold a 25% equity rate, even after purchases. If you don’t maintain at least 25% equity (in a margin account, remember), your brokerage may choose to sell your securities without your consent.
As you can see, there are a lot of specifics that accompany day trading, and that’s because it’s so risky. These nuances only add to the hours you’ll spend watching swing after swing of all your stocks on a daily basis.
Public.com doesn’t allow day trading of stocks, but the platform limits the activities of accounts that engage in day trading or the same day purchase and sale of a security.
Day trading risks in the stock market
In one 14-year-long study of day traders in the stock market, only 1% of day traders actually consistently earned money. Many investors even lost money.
Warnings about day trading risks are all over the place in the stock market business. Even the SEC gives a firm message about day trading, with warnings like “Be prepared to suffer severe financial losses” and “Day trading is an extremely stressful and expensive full-time job.” They also mention that active day traders perform trades on borrowed money.
So what’s the problem with trading on borrowed money? If you suffer a loss, you’re not just losing your own money; you’re also going into debt, which ultimately compounds your losses through potentially unsavory interest rates.
In February 2020, the stock market may have seen the largest decline in a single week since the 2008 Great Recession — but that sentiment doesn’t paint the full picture. The global COVID-19 pandemic has made day-to-day fluctuations their most active since 1929. The Great Crash occurred in September 1929, and it launched the economy into the Great Depression.
Today, many stocks are above where they were pre-pandemic. But there’s still a lot of uncertainty in the market, making day trading an even riskier venture. At this rate, who’s to say what the rest of a catastrophically historical year will bring? As we mentioned, day trading isn’t about playing the long game. And in a highly volatile market, this practice can make you lose money a lot easier than other investing strategies.
Despite all this, the year 2020 is seeing a surge in the number of individual retail traders. Some seasoned platforms are even seeing a 300% increase in new registrations. This makes sharing day trading risks and rules even more essential, if only to keep people from accidentally squashing their portfolios.
How day trading works: Is it different from other trading strategies?
Day trading is not one-and-the-same with other investing strategies. Let’s compare it to a few common investing strategies for beginners:
- Day trading vs swing trading: Whereas day trading occurs within the same day — and a pattern day trader does this multiple times a week — swing trading occurs over weeks or months. It isn’t a long-term strategy and it still counts on fluctuations, but it’s more invested in company performance or value than the alternative.
- Day trading vs long-term trading: Long-term trading occurs over the course of a year or more. Investors commonly put their money into index funds or ETFs for utmost diversification, ultimately using their gains for long-term goals like college or retirement.
- Day trading vs dividend investing: Dividend investors intentionally put money into stocks of companies that pay out dividends. This return is in addition to any capital gains you may get. On the contrary, day trading relies on small percentages of profit as a result of upward market swings throughout the day.
From just these few examples of investing strategies, it’s clear that day trading is a different ballgame. With that in mind, the risks and rules make sense.
Historically, investing in diversified portfolios for the long haul has proven itself as a solid way to grow wealth. Even swing trading has its perks, especially with the advent of commission-free apps that you can access right from your phone. But day trading is way riskier; more often than not, it leads to losses on borrowed funds. In the era of the pandemic, strong fluctuations only compound this risk. As an investor, it’s important to know the rules surrounding day trading (like how to avoid being a pattern day trader) and day trading risks, not just how day trading works.