The Right Account
To begin day-trading stocks, you must have a brokerage margin account with sufficient cash in it to pay for your trades. In a margin account, you can receive loans from your broker covering up to half the cost of the stocks you buy. Your stock positions collateralize the loans. Normally, you would not want to day-trade stocks in a non-margined, or cash, account, because the Federal Reserve Board's Regulation T requires that you pay for a security before buying and selling it, a process called settlement that takes three days in the US. You avoid the three-day delay by using a margin account. However, if you have a large amount of excess capital, you can use a non-margin account, as long as you observe Regulation T.
There are no regulations that specify how to day-trade, but simply buying and selling stocks without a plan can be quite risky. Day-traders often rely on strategies tied to one or more technical analysis methods that help decide which stocks to buy and sell and when to execute trades. Normally, you sit at a computer and work with a trading program, or platform, that allows you to convert your technical analysis into purchases and sales in your brokerage account. To limit risk, you can set target prices at which you take profits and stop-loss prices at which you close out losing trades.
Anyone with a brokerage margin account can day-trade, but to take advantage of IRS tax breaks, such as exclusion from the wash sale rules, you must become a pattern day-trader, which the IRS defines as someone who:
- seeks profits from daily price movements of traded securities, such as stocks, bonds and futures
- executes at least four day-trades within five business days. These trades must represent more than 6 percent of your total trades within the account over this time period.
- performs this activity regularly and continuously In addition, the Financial Industry Regulatory Authority requires that you maintain at least $25,000 in cash and securities within your day-trading account. Pattern day-traders who elect mark-to-market accounting -- in which you recognize all your gains and losses before the end of the year -- can treat their gains and losses as business income, which allows them to deduct certain expenses and take better advantage of certain losses.
Day-Trading Is Risky
A study in the April 2000 issue of The Journal of Finance[http://faculty.haas.berkeley.edu/odean/papers%20current%20versions/individual_investor_performance_final.pdf] uses academic research to reach the conclusion that frequent trading is the result of overconfidence and is hazardous to your wealth. This doesn't mean you won't be successful as a day-trader, but it should help you set your expectations and take steps to control your risks, including limiting the size of any one trade, using stops to cut losses early, learning from your mistakes and exercising discipline in whatever strategies you choose to follow. In general, day-traders should be prepared to suffer severe financial losses.