Last Updated on 3 November, 2022 by Samuelsson
Knowing what is legal and illegal in trading is a lesson that no one wants to learn the hard way. One question that sometimes arises when it comes to day trading, is if day trading is legal.
Daytrading is legal. The rumor of day-trading not being legal comes from misconceptions regarding the “pattern day trader rule”. The pattern day trader rule states that margin accounts with an account balance of less than $25 000 are limited to three daytrades within five consecutive trading days.
So, let’s have a look at what restrictions the pattern day trader rule imposes on traders.
What Is the Pattern Day Trader Rule?
The Pattern Day Trader Rule applies to traders who trade on margin accounts and states that they need to have more than $25,000 in assets if they want to perform frequent day trading.
The Financial Industry Regulatory authority (FINRA) implemented this rule on all brokers that come under its regulation. According to the rule, a trader is considered a “pattern day trader” if they perform more than three day trades within five consecutive working days. The FINRA considers a daytrade to be a position that is opened and closed within the same trading day.
In order to not fall under this regulation as a day trader, you need to have an account value of $25,000 or more.
Now, nowhere in the rule does it say that day trading is illegal. Moreover, the pattern day trading rule itself only applies to margin accounts. Even if a trader violates the pattern day trader rule, the only inconvenience that they will face is a locked account. They can still trade from other cash or margin-based accounts with other brokers and there certainly will be no legal repercussions.
Note: the $25,000 in assets can be in two forms. Either those assets can be cash or admissible securities. Having cash in the account has the advantage that its value does not fluctuate over time.
Why Was It Created?
To rest this debate once and for all, it makes sense to understand the reason behind creating day trading rule.
The day trader pattern rule was partly created in order to cushion the books of margin account brokers against potential default risk. However, the main reason why it was created was to protect traders with little knowledge and experience to participate in margin trading, which comes with very high risks for the trader, compared to cash accounts.
Futures Trading as an Alternative
If you do want to day trade on margin with less than $25 000, you could resort to the futures markets!
Futures are great if you want a lot of leverage. They offer exceptional liquidity for the larger equity indexes like the SP 500, and of course, the day trader pattern rule does not apply to futures accounts!
Here are some of the main benefits of trading futures:
Leverage: Futures come with inbuilt leverage, which means that you control more of the underlying asset than what it costs to keep the position open. However, as always, leverage is a double-edged sword that must be used with caution!
Liquidity: Futures offer high liquidity in many markets where competing ETF:s or other securities might not have enough volume.
No Short Selling Restrictions: Unlike stocks or other securities, there are no restrictions for those who wish to short the market. This makes futures the perfect choice for those who always want to have the option to go short, regardless of what happens in the market!
Low Costs: Futures are very cost-effective, since trading fees become very small in relation to the gained market exposure.
So if you are looking into trading on margin, futures definitely are a great choice, and offer a lot of possibilities!
Related reading: Is Swing Trading Illegal?
Alternatives to Day Trading
Though day trading can be a lucrative strategy, doing it on a margin account without $25,000, in liquid assets, can become problematic. In those cases there is another alternative, namely, swing trading.
In swing trading, traders buy an asset overnight. The holding time depends on the swing strategy and the type of asset being held but is generally somewhere between a few days to a few weeks.
Swing trading strikes a balance between short term intraday trading and long-term trading. In swing trading, an investor will buy an asset and then hold that asset for up to a month. The exact holding period will depend on the asset type, the strategy, and conditions of the market. Swing trading most often uses technical analysis and hopes to capture medium-term upward movements in asset prices.
Advantages of swing trading
Swing trading is an attractive option for many investors on a number of grounds.
First, it takes very little time. With a good strategy in place, picking your candidates after the market has closed and sending the orders to the market could take as little as 15 minutes! Also, swing trading is a good gateway to daytrading, since it is easier and will let you brush up your skills before you advance to day trading, which is much harder!
Swing trading also has the advantage of being less stressful than day trading. You can take your time when picking your candidates knowing that the market is closed and that your order is going to be executed first tomorrow morning! That is quite a big contrast to day trading!
Lastly and most importantly, swing trading is ideal for investors who have to perform a day job. This is because that you place your orders when the market is closed, which is when most people are not working. Also, during the opening hours of the market, placing a stop loss at an appropriate level will ensure that risk is handled responsibly! This ensures good risk handling while at the same time allowing you to focus on your other responsibilities such as your day time job.
Can you combine swing trading with a full-time job? Read our article to find out more on this topic!
The pattern day trader rule is a FINRA based regulation that only applies to pattern day traders using margin accounts. This rule limits trading for margin-based day traders that have less than $25,000 in their accounts. Unfortunately, some traders have confused this rule with day trading as a whole being illegal.
However, for traders who still want to use margin in their trading, there are other options. For those who insist on staying with daytrading, trading futures might be a good option. For others, swing trading is a good way of learning the markets in hopes of one day advancing to real day trading!