Last Updated on 20 February, 2021 by Samuelsson
A day trading career may have some attractive features, such as being your own boss, working with your own timetable, doing it from the comfort of your own home and even in your pajamas if you want, not dealing with difficult people, and so on. But how much capital do you need to become a day trader?
Well, there is no simple answer to this because everyone’s goals and financial situations are different, and moreover, the security and market you intend to trade matter a lot. In the U.S. stock market, you are expected to maintain a $25,000 to be able to place more than 4 trades in 5 consecutive trading days. However, while you can still day-trade stocks if you don’t have up to that amount, you should start with an amount that can cover all the necessary costs and still allow you to make a reasonable return for your effort.
In this post, you will learn the factors that affect how much you will need for day trading, the pattern day trader rule in the US, and how to estimate how much to budget for your day trading. But first, we will explain what it means to be a day trader.
What it means to be a day trader
A day trader refers to someone who buys and sells a financial security on the same trading day. This style of trading is called day trading and can be used in any market, but it is most commonly practiced in the Forex and stock markets. Since the Forex market is decentralized and trades all day long across different sessions, day traders in the forex market can trade at any time they want but must close their trades on the same day. In the stock market, on the other hand, the trades are usually placed after the market opens and closed before the closing bell, so day traders have to trade during those hours.
Making money from day trading requires a good strategy with a proven edge in the market, which the day trader must execute very efficiently. Since it is normal to use leverage and short-term trading strategies to capitalize on small price movements that occur in highly liquid stocks, a day trader must have a robust trading plan and always follow the plan.
Day traders use different strategies that are designed to capture intra-day moves in the market. The strategies can be based on technical analysis, which may be executed manually or with an automated system. However, some traders mostly aim to capture the price reactions that follow scheduled new events, such as economic statistics, corporate earnings, or interest rates. These news events tend to cause intra-day market movement when the actual data beat or do not meet expectations. Some day traders create algorithmic systems that automate their trading strategies, while others trade their strategies manually. Whether manual or automated, day trading is not for everyone, as it involves significant risks.
Unlike the decentralized Forex market where there are no general rules regarding how much the trader must have to be able to trade, the U.S. stock market has rules regarding the minimum capital a trader must maintain as a day trader. So, let’s take a look at that.
Factors that determine how much you need to become a day trader
As we hinted earlier, the amount you need to start day trading differs, depending on the individual’s circumstances. For example, the amount a day trader in the forex market will need to start trading will be different from what a stock day trader needs. Generally, the amount you need to start day trading depends on different factors:
- The security you want to trade
- The market of interest
- Other costs of trading
The amount you will need for day trading depends on the security you want to trade. Is it currencies, stocks, or commodities? The amount varies for whichever security you chose to trade. If you choose to trade U.S. stocks, for example, you will have to maintain more than $25,000 in your brokerage account, and of course, it has to be a margins account. Without that, you will be limited to trading with a cash brokerage account, and you will only be able to make 3 trades in five consecutive trading days.
But this is not the same for foreign exchange trading, where there are no central regulations. So, each broker sets their own minimum initial deposit and maintenance margin. Some brokers can allow you to trade with as low as $100 or $50 or even lower. In this case, the amount you start with will mostly depend on what you can afford to comfortably risk in the market. So, if you can afford only afford to start with $100, that’s fine, and if you afford to start with $50,000 or $100,000, that is your choice.
It is something similar for those who wish to trade commodities, which are usually traded in the futures market. Futures brokers have the liberty to set their various minimum deposits and maintenance margins. Many of them accept a deposit of $1,000 or even a few hundred dollars. But you may need to have up to $5,000 to be able to trade standard contracts because the leverage is often capped at x20. So, for commodity futures, you may need between $500 and $5,000 if you want to trade it.
However, in this post, we will be focusing on stocks and stock indices because those are the securities we mostly trade. The next factor we will consider is the market.
From our discussion so far, you can see that the market you trade can determine how much capital you will need to become a day trader. Since our focus is on stocks, what we mean by the market here is the stock market or exchange where you intend to trade. To trade in the U.S. stock market as a day trader, you will need to maintain a minimum of $25,000 at all times, which means that you must start with more than that amount to be able to cover any losses that may come. It is only day traders who meet this rule that can be allowed to trade 4 or more times in 5 consecutive trading days — what is often known as pattern day trading.
This is not the case in other stock markets. Most stock markets around the world don’t have any specific restrictions for day trading. So, if you want to trade in the Asian stock markets, such as the Japanese, South Korean, and Singaporean stock market, you don’t need to maintain a minimum of $25,000 in your account as it is required in the U.S. stock market. Similarly, the London Stock Exchange and other European stock markets have no such restrictions on day trading, so you need not keep a minimum of $25,000 before you can trade them. The amount you trade with will depend on your personal trading situations and goals.
You can day-trade many of these international stock markets with a far lesser amount. Even if you are resident in the United States, there are online international brokers that offer access to all these foreign stock markets. If you open an account with them, you can day-trade in any of those foreign stock markets. A good example of such an online broker that offers international trading is Interactive Brokers.
Other trading costs to consider
Apart from any compulsory minimum deposit requirement placed by the stock exchange or your broker for day trading, there are other costs you will incur in day trading, which you must consider to know the actual amount you should budget for your day trading. Those trading costs include the following:
1. Cost of the trading platform, market data, and education
Some brokers, like TradeStation, offer advanced trading platforms at no cost for all their clients. Other brokers just offer very rudimentary order execution platforms that lack many of the features you may need as a day trader. If the trading platform and its features are important to you, look around to see what’s offered by the various brokers. But you should know that there is usually a high monthly subscription fee for those bigger platforms with many interesting features if you don’t have an account with the parent brokerage firm. So, if you plan to use a third-party platform, consider the cost and budget accordingly.
In addition to the trading platform itself, you will need market data — both the historical data for backtesting your strategy and the live market data for your trading. While some brokerage platforms may provide them free of charge, others don’t. So, you have to budget for them. You might want to also consider the educational resources that the broker offers to you as a client. Many brokers attempt to increase the attractiveness of their brokerage services by including vast libraries of educational material. These educational resources may help you to master your trading faster.
2. Account Fees
Another cost to consider is certain account fees charged by the broker, such as annual fees or inactivity fees. As we stated earlier, some may charge subscription fees for market data and trading platforms. Many brokers won’t charge you most of the fees above, but it’s always worth taking an extra look to ensure that you are not paying any unnecessary fees. Whatever extra fees you have to pay should be included in your budget.
3. Commissions and transactional fees
As a day trader, you will be placing a lot of trades, with the average return per trade being quite small. So, the impact of incurring trading-related costs, like commissions and other transactional costs, will have a huge impact on your performance. Thus, you should try to lower your transactional costs as much as possible, in order to retain the greater portion of the profits you make. It won’t make sense to per make $3 per share in profits and pay $2 per share in commissions and transactional costs.
Unfortunately, some traders forget about transactional costs or may not even realize the impact it will have on their trading strategies and methods. In fact, many times it will be a break or make a factor, where higher transactional costs could even turn a profitable trading strategy into a losing one. It is, therefore, very important that you account for these costs when budgeting your initial trading capital because before you starting making profits, it’s your initial capital that covers the costs of transactions. Be sure to check out the cost structure of your broker before making a final decision.
The pattern day trader rule
Before we go into the pattern day trader rule established by the Financial Industry Regulatory Authority (FINRA), let’s see how the regulators define a day trade. According to the U.S. Security and Exchange Commission (SEC), a day trade is defined as “the purchasing and selling or the selling and purchasing of the same security on the same day in a margin account.”
The SEC further notes: “This definition encompasses any security, including options. Also, selling short and purchasing to cover the same security on the same day is considered a day trade. Exceptions to this definition include:
- a long security position held overnight and sold the next day prior to any new purchase of the same security; or
- a short security position held overnight and purchased the next day prior to any new sale of the same ”
With this in mind, let’s look at the FINRA rule. The FINRA rules define a pattern day trader as 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 business day period. Under the rules, a pattern day trader must maintain minimum equity of $25,000 on any day that they day trades. The required minimum equity must be in the account prior to any day-trading activities, and if the account falls below the $25,000 requirement, the pattern day trader will not be permitted to day trade until the account is restored to the $25,000 minimum equity level.
From both definitions, it is obvious that pattern day traders may trade different types of securities, including stock options and short sales, and any type of trade will be accounted for, in terms of this designation, as long as they occur on the same day. Furthermore, when there is a margin call, the pattern day trader will have five business days to answer it, and their trading will be restricted to that of two times the maintenance margin until the call has been met. If they don’t address the issue after five business days, they will get a 90-day cash restricted account status, or the restriction will remain until such time that the issues have been resolved.
While this rule is a minimum requirement, some broker-dealers may use a slightly broader definition in determining whether a customer qualifies as a “pattern day trader.” A broker-dealer may designate a customer as a pattern day trader if it “knows or has a reasonable basis to believe” that a customer will engage in pattern day trading. For instance, if a customer’s broker-dealer provided day trading training to the customer before opening an account, the broker-dealer could designate that customer as a pattern day trader. To know exactly how your broker interprets the rule, get in touch with them.
The significance of the pattern day trader rule
The implication of the rules is that all traders who hold less than $25,000 are restricted to 3 trades per 5 consecutive business days. These traders can trade from their regular cash account instead of a margin account. The reason why this rule was established was to protect day traders with little experience and knowledge from margin trading, which comes with much higher risks than a typical cash account.
However, there are a few ways to bypass the rules and day-trade stocks if you don’t have up to $25,000. One of them is to trades stocks in other markets outside the US. Another option is to open multiple accounts with different brokers since the restriction to 3 trades per 5 business days only applies to one account. So, for example, if you have a $5,000 account with 3 different brokers, all together, you can make up to 9 trades per 5 business days.
Determining the amount you will need to start day trading
So far, we have discussed the margin rules for day trading and the other costs you may have to take care of in day trading. To determine how much you will need to start day trading, consider your own situation regarding the margin status and your broker’s minimum requirement but also remember to add the other costs.
For those who qualify as pattern day traders
If you can afford to maintain a minimum of $25,000 equity in your account, then you qualify as a pattern day trader. But note that because of the extra costs we discussed above and the fact that you may have losses at the beginning, you will need to budget more than the required $25,000 maintenance margin.
About $30,000 may be fine for a pattern day trader. This can cover the extra costs required for getting started, such as the subscription fees for the trading platform and market data. For someone who risks only 1-2% of the account balance per trade, it will also be able to cover for the first few trades in case they end up as losses.
For those who don’t qualify as pattern day traders
If you cannot afford the required $25,000 maintenance margin but still want to day-trade stocks, you can trade other stock markets outside the US, and interestingly, stocks of several U.S. companies are quoted on many exchanges around the world. There are many online brokers that offer international trading. Alternatively, you can open an account with multiple U.S. brokers to be able to trade more than 3 times in 5 business days.
Having said that, here are two ways you can estimate how much to start with. Whatever you arrive at, remember to add the extra costs for the platform, market data, and others.
1. Use an amount that can offer you a return that is worth your effort
While many brokers may allow you to start with as little as $500 or $1000, it may be too small to make any significant return that would be worth your effort. Many people might tell you to use leverage to multiply your profit potential, but excessive use of leverage is a double-edged sword — while you may make more money, it can quickly decimate your account.
Our recommendation is this: start with an amount that makes all the hard work worth your effort. Let’s assume that you can, realistically, make a 30% annual return on average. If you start with only $1,000, at the end of a full year of hard work, you will make only $300, which might not be worth the effort. Moreover, the $300 may not be enough to cover all those extra costs, like subscription fees. In other words, you need to consider an amount that will provide a return that makes the effort worth your time!
2. Consider your affordable risk per trade
Another way to estimate the amount you need will be to look at it from the bottom-up angle. By this, we mean how much you can afford to lose per trade without feeling bad. For example, if you can afford to lose $100 in a trade without any problem, then $100 is what you can bet in each trade.
We often recommend that traders should risk only about 1% of their account size per trade. So, if that 1% amounts to $100, then your account size should be (100% x $100)/1% = $10,000. This is just a simplistic estimation. You should also make room for all the extra costs we discussed above.