Day Trading Rules: Everything You Need To Know
Few approaches to stock trading garner as much fascination as day trading. Day traders are speculators who buy and sell stocks or other financial instruments within the same trading day in an attempt to reap profits from the constantly shifting prices.
Day trading might sound like a great way to reap big returns, but in reality, it’s extremely risky and rarely profitable. Even compared to other notoriously volatile enterprises like penny stock trading, day trading is less likely to result in success. The website of the Securities and Exchange Commission warns that day traders “typically suffer severe financial losses in their first months of trading, and many never graduate to profit-making status.”
Despite these kinds of dire warnings, many people still think they can beat the odds by day trading, or maybe they just get sucked in by the thrill of the action. That was especially true during the COVID-19 pandemic, when the combination of commission-free trades on platforms like Robinhood and boredom from social distancing led to a day trading boom in 2020, as reported by CNBC Make It.
If you want to try your hand at day trading stocks, here’s a look at 10 day trading rules and tips you need to know before getting started.
1. Don’t Do It
Just don’t. Day trading is, generally speaking, a really bad idea — particularly if your goal is to make money. There’s a reason the only people who usually advocate day trading are those trying to sell books or classes about it.
A study published in June 2020 found that of nearly 1,600 Brazilian day traders who were tracked for a year, only 3% actually made money, CNBC reported. The authors of the study concluded that “it is virtually impossible” to day trade for a living.
Another study, published in October 2020, examined the day trading activity of Robinhood users from May 2, 2018, to Aug. 13, 2020. It found that big increases in Robinhood users are often accompanied by large price spikes, and then followed by “reliably negative” returns.
If you’re interested in day trading because it sounds exciting and the money isn’t important to you, it could be a fun but extremely risky hobby. But if you’re looking for a source of income or a way to grow your retirement account, remember the first rule of day trading: Don’t do it.
2. Know the Lingo
If you do decide to start day trading, it’s important to understand some key terminology. Here’s a quick primer:
- Leverage: Increasing the money behind a given trade to maximize the potential returns
- Margin trading: Borrowing money — usually from your broker — and using that money to speculate on financial markets
- Entry point: The price at which you purchase the stock or other instrument you’re trading
- Exit point: The price at which you sell to exit the position
- Bid-ask system: The basic system for the buying and selling of stocks and other securities. Anyone interested in buying a stock enters a “bid” — the price they want to pay — while anyone wishing to sell a stock enters an “ask,” or the price they want to sell at.
- Market order: An order for a stock trade that is to be executed at the prevailing market price
- Limit order: An order for a stock trade that will only be executed at the bid or ask price included in the order
3. You Need at Least $25,000
The Financial Industry Regulatory Authority requires that anyone engaged in day trading maintain at least $25,000 in their brokerage account, known as the “pattern day trading rule.” If you buy and sell a stock or other security within the same day four or more times in five business days, you’ll be considered a pattern day trader and need to meet the rule’s requirements.
This rule also reflects another important reality: You need a lot of money to day trade. Most trades will involve relatively slim margins — especially after fees — so you need to put a lot of money behind them to turn a substantial profit. That’s why beginners should use a stock trading simulator prior to putting actual cash behind their efforts.
4. Expect To Do Margin Trading …
Because day traders realize a very small gain (if any) for each share they trade, they need leverage to buy up more shares — usually in the form of margin trading. By borrowing from your broker, you can double the size of your trade. Just keep in mind that under the Federal Reserve Board’s Regulation T, firms can only lend a customer up to 50% of the total purchase price of a margin security for new purchases.
Margin trading comes with considerable risk. Borrowing the maximum could mean substantial profits when you succeed — but it also means substantial losses when you don’t. This can quickly push you deep into debt with your broker. You’ll also pay interest on any money you borrow.
5. … or Options Trading
One other way to get leverage is through options. These are contracts that let you buy or sell a stock or other security or commodity at a specific price in the future. Because the price of the contract is much lower than the price of a stock, you can buy contracts that represent many more shares than you could otherwise afford.
Stock options trading comes with its own risks. Options contracts that don’t get “in the money” are worthless, so a failed trade often involves losing everything you put behind it. But success usually magnifies your potential returns. And unlike margin trading, you aren’t in danger of losing borrowed money. Regardless, options can be very complex and should be extensively researched before you take the plunge.
6. Short-Term Investing Means Higher Taxes
The capital gains tax favors long-term over short-term investors, meaning day traders will face a higher tax bill for any profits they realized. When you make money by selling stocks held for less than a year, you’ll pay the short-term capital gains tax rate, which can rise as high as 37%. Gains on stocks held for more than a year are taxed at a much lower rate — no more than 15% for most people, with a cap at 20%.
7. Only Use Money You Can Afford To Lose
Because day trading is so risky and you stand a pretty high chance of losing money, make sure that any money you set aside for day trading is money you can afford to lose. Never dip into funds that are allocated for day-to-day living, important bills or emergency funds.
8. Build a Strategy
One of the biggest mistakes made by novice traders is trying to “read” the market to capitalize on sudden swings in stock prices. Most veteran traders prefer to develop a clear, executable strategy ahead of time and then follow it carefully.
Make a Trading Plan
Before you trade, you should have a clear sense of your planned entry point, exit point and stops. Better still, if your online stock trading software has the option to automate your trades, you can be sure your emotions won’t drive you to make mistakes.
9. Always Use Limit Orders
Your strategy should be built around very specific stock trading information about the sort of patterns that emerge in the way a particular stock trades, so it’s important to have a precise sense of what price you want to buy and sell at. Market orders can easily end up executing at different prices from where stocks are trading when you enter them. The best plan is to stick to limit orders that will only execute on your terms.
10. And Also Limit the Number of Stocks
As a beginner, you should focus on one to two stocks during a day trading session. This will simplify the process of tracking and finding opportunities and make it easier to know when to exit at the right time.
Takeaways on Day Trading
Here are a few takeaways to keep in mind when considering day trading:
- Avoid penny stocks if you’re just starting out as a day trader because they are very illiquid and there’s little chance you’ll reap a profit from them.
- Similarly, novice day traders should avoid making any moves during the first 15 to 20 minutes after the market opens, which tends to be a period of high volatility. Wait for the middle hours of the trading session, which are usually much less volatile.
- Avoid acting on “hot tips” and “expert advice” from newsletters and websites that cater to day traders — especially those that claim you can make easy profits. That simply doesn’t happen for the vast majority of day traders.
Vance Cariaga contributed to the reporting for this article.
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