Disclaimer: Margin trading is highly speculative. You should only attempt margin trading if you completely understand your potential losses and you have solid risk management strategies in place.
Day trading involves buying and selling the same stocks multiple times during trading hours in hope of locking in quick profits from the movement in stock prices. Day trading is risky, as it's dependent on the fluctuations in stock prices on one given day, and it can result in substantial losses in a very short period of time.
- Trading on margin allows you to borrow funds from your broker in order to purchase more shares than the cash in your account would allow for on its own. Margin trading also allows for short-selling.
- By using leverage, margin lets you amplify your potential returns - as well as your losses.
- Margin calls and maintenance margin are required, which can add up losses in the event a trades go sour.
Margin and Day Trading
Buying on margin, on the other hand, is a tool that facilitates trading even for those who don’t have the requisite amount of cash on hand. Buying on margin enhances a trader's buying power by allowing them to buy for a greater amount than they have cash for; the shortfall is filled by a brokerage firm at interest. When the two tools are combined in the form of day trading on margin, risks are accentuated. And going by the dictum, “the higher the risk, the higher the potential return,” the returns can be manyfold. But be warned: There are no guarantees.
The Financial Industry Regulatory Authority (FINRA) rules define a day trade as “The purchasing and selling or the selling and purchasing of the same security on the same day in a margin account.” The short-selling and purchases to cover the same security on the same day along with options also fall under the purview of a day trade.
When we talk about day trading, some may indulge in it only occasionally and would have different margin requirements from those who can be tagged as “pattern day traders.” Let’s understand these terms along with the margin rules and requirements by FINRA.
A term pattern day trader is used for someone who executes four or more day trades within five business days, provided one of two things: 1) The number of day trades is more than 6% of his total trades in the margin account during the same five-day period, or 2) The person indulges in two unmet day trade calls within a time span of 90 days. A non-pattern day trader's account incurs day trading only occasionally.
However, if any of the above criteria are met, then a non-pattern day trader account will be designated as a pattern day trader account. But if a pattern day trader's account has not carried out any day trades for 60 consecutive days, then its status is reversed to a non-pattern day trader account.
To trade on margin, investors must deposit enough cash or eligible securities that meet the initial margin requirement with a brokerage firm. According to the Fed's Regulation T, investors can borrow up to 50% of the total cost of purchase on margin and the remaining 50% is deposited by the trader as the initial margin requirement.
The maintenance margin requirements for a pattern day trader are much higher than that for a non-pattern day trader. The minimum equity requirement for a pattern day trader is $25,000 (or 25% of the total market value of securities, whichever is higher) while that for a non-pattern day trader is $2,000. Every day trading account must meet this requirement independently and not through cross-guaranteeing different accounts. In situations when the account falls below this stipulated figure of $25,000, further trading is not permitted until the account is replenished.
A margin call occurs if your account falls below the maintenance margin amount. A margin call is a demand from your brokerage for you to add money to your account or close out positions to bring your account back to the required level. If you do not meet the margin call, your brokerage firm can close out any open positions in order to bring the account back up to the minimum value. Your brokerage firm can do this without your approval and can choose which position(s) to liquidate. In addition, your brokerage firm can charge you a commission for the transaction(s). You are responsible for any losses sustained during this process, and your brokerage firm may liquidate enough shares or contracts to exceed the initial margin requirement.
Margin Buying Power
The buying power for a pattern day trader is four times the excess of the maintenance margin as of the closing of business of the previous day (say an account has $35,000 after the previous day's trade, then the excess here is $10,000 as this amount is over and above the minimum requirement of $25,000. This would give a buying power of $40,000 (4 x $10,000). If this is exceeded, then the trader will receive a day trading margin call issued by the brokerage firm. There is a time span of five business days to meet the margin call. During this period, the day trading buying power is restricted to two times the maintenance margin excess. In case of failure to meet the margin during the stipulated time period, further trading is only allowed on a cash available basis for 90 days, or until the call is met.
Example of Trading on Margin
Assume that a trader has $20,000 more than the maintenance margin amount. This will provide the trader with a day trading buying power of $80,000 (4 x $20,000). If the trader indulges in buying $80,000 of PQR Corp at 9:45 a.m. followed by $60,000 of XYZ Corp. at 10.05 a.m. on the same day, then he has exceeded his buying power limit. Even if he subsequently sells both during the afternoon trade, he will receive a day trading margin call the next day. However, the trader could have avoided the margin call by selling off PQR Corp before buying XYZ Corp.
Note: Though the brokers must operate within the parameters issued by the regulatory authorities, they do have the discretion to make minor amendments in the laid requirements called “house requirements.” A broker-dealer may classify a customer as a pattern day trader by bringing them under their broader definition of a pattern day trader. Also, brokerage firms may impose higher margin requirements or restrict buying power. Thus, there can be variations depending upon the broker-dealer you choose to trade with.
The Bottom Line
Day trading on margin is a risky exercise and should not be tried by novices. People who have experience in day trading also need to be careful when using margin for the same. Using margin gives traders an enhanced buying power however; it should be used prudently for day trading so that traders do not end up incurring huge losses. Restricting yourself to limits set for the margin account can reduce the margin calls and hence the requirement for additional funds. If you are trying day trading for the first time, don’t experiment with a margin account.