Day Trading

Many broker-dealers earn a substantial part of their revenue and profits from day-trading customers. Institutional customers are free to day-trade without the broker-dealer having to protect the investor from himself. But, for retail customers, broker-dealers follow stringent rules for opening and handling day-trading accounts.

As FINRA stipulates, "to approve a customer's account for a day-trading strategy, a member shall have reasonable grounds for believing that the day-trading strategy is appropriate for the customer. In making this determination, the member shall exercise reasonable diligence to ascertain the essential facts relative to the customer." 

FINRA then lists 7 specific items:
(1)    Investment objectives;
(2)    Investment and trading experience and knowledge (e.g., number of years, size, frequency and type of transactions);
(3)    Financial situation, including: estimated annual income from all sources, estimated net worth (exclusive of family residence), and estimated liquid net worth (cash, securities, other);
(4)    Tax status;
(5)    Employment status (name of employer, self-employed or retired);
(6)    Marital status and number of dependents;
(7)    And age.

Does that mean if the broker-dealer knows this customer is married, self-employed and has no day-trading experience, that day-trading might be an appropriate strategy to recommend?
Probably not. If the investor is in the top two tax brackets, does it make sense for him to generate short-term capital gains, taxed as high as almost 40%? Again, probably not.
Because there is so much risk involved with day-trading, FINRA does not allow member firms to open non-institutional day-trading accounts without providing required disclosures.

As the rules state: no member that is promoting a day-trading strategy, directly or indirectly, shall open an account for or on behalf of a non-institutional customer, unless, prior to opening the account, the member has furnished to the customer the risk disclosure statement and has:

(1)    approved the customer's account for a day-trading strategy in accordance with the procedures set forth in paragraph (b) and prepared a record setting forth the basis on which the member has approved the customer's account; or

(2)    received from the customer a written agreement that the customer does not intend to use the account for the purpose of engaging in a day-trad¬ing strategy, except that the member may not rely on such agreement if the member knows that the customer intends to use the account for the purpose of engaging in a day-trading strategy.

The main bullet points this document makes to the customer include:
•    Day-trading can be extremely risky
•    Be cautious of claims of large profits from day-trading
•    Day-trading requires knowledge of securities markets
•    Day-trading requires knowledge of a firm's operations
•    Day-trading will generate substantial commissions, even if the per-trade cost is low
•    Day-trading on margin or short selling may result in losses beyond your initial investment

The term "day trading" is defined by FINRA as, "the purchasing and selling or the selling and purchasing of the same security on the same day in a margin account." The exceptions to the definition include purchasing a stock held overnight if the position is sold before buying any more of that stock, or if a short-seller keeps a short-position open overnight, covering it before selling any more of those shares short.

The term "pattern day trader" is defined as, "any customer who executes four or more day trades within five business days. However, if the number of day trades is 6 percent or less of total trades for the five-business-day period, the customer will not be considered a pattern day trader and the special requirements will not apply."

Day traders are in margin accounts, and their buying power is significantly higher than the typical retail margin account.

FINRA defines day trading buying power as:
"The equity in a customer's account at the close of business of the previous day less any maintenance margin requirement, multiplied by four for equip) securities."   

If the customer's long positions are worth $100,000, and his debit balance is $30,000, he has $70,000 of equity. According to FINRAs definition, his buying power is four times his equity of $70,000, or $280,000.

What happens when a customer's minimum equity is insufficient under these rules? FINRA explains that, "when the equity in a customer's account is not sufficient to meet the day trading requirements of this paragraph, additional cash or securities must be received into the account to meet any deficiency within five business days of the trade date."

Pattern day traders have special requirements. The minimum equity requirement for pattern day traders is $25,000. That equity "must be deposited in the account before the customer may continue day trading and must be maintained in the customer's account at all times."


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