With the arrival of electronic trading, day trading has become increasingly popular with individual investors. This trading technique involves buying and selling tradeable assets, such as a stock, ETF, or another financial instrument within the same day. What makes day traders different from swing traders and trend traders is the investment strategy or trading strategy. Day traders close their position before the end of the trading day and do not hold their assets overnight.
While day trading can be profitable, it can be risky and stressful. Whether you’re trading shares of the top tech stocks of the year or working on a strategy to buy and trade undervalued tech stocks, it’s essential that you know the critical day trading laws and regulations involved before you get started.
1. Day Trading Margin Requirements
On February 27, 2001, the Securities and Exchange Commission (SEC) approved both the NASD and NYSE day trading margin rules. The NASD rules went into effect on September 28, 2001.
Pattern Day Trader
The day-trading margin requirements are also known as the “pattern day trading” regulation. You are a pattern day trader if you are a stock trading customer that day trades at least four times within five business days (provided that the number of day trades is more than six percent of the trader’s total trading activity for the same five-day period).
Additionally, your brokerage firm may designate you as a pattern day trader if there is a reasonable basis. For example, a brokerage firm that provided you day trading training before opening your account may designate you as a pattern day trader.
Day Trading Minimum Equity Requirement
The margin requirement is that the day trader must maintain a minimum equity requirement of $25,000 in his account balance at all times. The purpose of the margin rule is to provide sufficient funds to support the risks associated with day trading. If a customer’s account falls below the $25,000 requirement, the customer will not be permitted to day trade.
Before this, in 1974, the minimum equity balance was $2,000. However, with the arrival of electronic trading, the speed of trading changed drastically. Traders are now able to get in and out of trades with the same day, which increases the inherent risks associated with particular patterns of day trading, such as the use of cross-guarantees.
The minimum equity requirement only applies to U.S. stock markets and financial markets. For example, the U.S. futures and currency markets don’t have pre-determined equity minimum requirements for day traders, except for deposit minimums and margin requirements as required by your broker.
Day Trading Margin Calls
If a customer does not have a security position at the end of the day, he will likely face a margin call. Margin calls got their name because the brokerage would call the trader and request more funds as collateral to allow the trade to proceed. The margin requirement is designed to alleviate some risk and possibly satisfy a margin call.
Most margin requirements are determined based on a customer’s securities’ largest open position at the end of the trading day.
If you cannot reach the $25,000 minimum required of a pattern day trader, there are a few alternatives around the day trading law.
First, you can make three trades in a five-day period and be exempt from the minimum equity requirement.
Second, you can consider to day trade a stock market outside of the United States. It is recommended to research the account minimums and day trading rules in foreign stock markets and consult a tax and legal professional to understand the ramifications of international stock markets.
Third, work for a day trader firm. Each firm will likely require a different amount of personal capital. However, the firm should also leverage your equity and provide you with more funds to trade.
Fourth, day trade with a cash account and avoid margin. The margin requirements are to mitigate risk so that a day trader does not exceed his day trading buying power. However, if you only trade with cash, you won’t be subject to the pattern day trader rule, but you’ll be more limited on funds.
2. How to Apply for the IRS Day Trader Designation or Trader Tax Status
The IRS views an investor who occasionally trades and a day trader differently. Although there are no current statutory laws with objective tests for eligibility, leading tax publishers have interpreted case law as well as the IRS’ special rules for traders to determine trader tax status or TTS.
For example, Chapter 4 in the IRS Publication 550, “Special Rules for Traders in Securities” states that a trader must “seek profits from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation,” and have substantial as well as continuous and regular activity.
To fulfill the IRS substantial activity rule, you likely need to trade full time, spend at least four hours per day, have only a few occasional lapses, and intend on making a living from this income.
Of course, tax law and day trading laws don’t give bright-line tests with precise numbers. There’s no election for Trader Tax Status. A trader may be designated as a day trader one year, and merely an investor the next year. It is recommended to keep scrupulous records of your trading activity and to consult with a professional tax expert.
3. Benefits of a Day Trader Designation or Trader Tax Status
There are several advantages if the IRS designates you as a day trader. With trader tax status, you have the ability to make the mark-to-marketing election. This election means that your securities are taxed on realized (what you sold) and unrealized (still open) gains or losses at the end of the year. Be sure to consult a tax professional before claiming the Section 475 election Mark-to-Marketing to confirm this election is best for your investment portfolio.
Wash Sale Restriction
IRS tax laws exempt day traders with a mark-to-market election from wash sale restrictions.
In a wash sale, traders sell stocks or securities at a loss and then reacquire the same security within 30 days. Wash sale day trading regulations dictate that the loss cannot be deducted or used to offset a capital gain.
As a designated day trader with a mark-to-market election, however, you are exempt from the wash sale regulations. Therefore, the loss is now considered a business loss and is fully deductible.
Capital Loss Limits
IRS tax laws exempt day traders from capital loss limits. As an investor in the eyes of the IRS, you may only deduct $3,000 worth of capital losses. However, a trader who elects mark-to-market, there is no capital loss limit.
You may report all your losses (and gains) on Form 4797, Sale of Business Property, in Part II, Ordinary Gains and Losses. In this case, you would not complete Schedule D. After completing Form 4797, you can then transfer the gain or loss directly to your 1040 income tax return. To qualify for unlimited capital loss deductions, day traders must trade the same stock within a 30-day window.
If you are not a member of a financial firm, you are probably considered self-employed. As a result, you can deduct all of your investing expenses such as your laptop, Internet service and cellphone service on the Schedule C of Form 1040.
An investor who makes fewer trades may write off expenses on Schedule A. Unfortunately, only investment expenses that exceed 2 percent of their adjusted gross income or AGI can be deducted.
Additionally, some day traders borrow money on margin. When setting up a brokerage account, a cash account is limited to the amount of money that the investor deposits. On the other hand, a margin account allows a trader to borrow money to buy stocks. This increases a day trader’s leverage with potential for higher gains. However, this also exposes traders to losses that may exceed his collateral or equity on hand.
If a day trader chooses to buy on margin, they may write off margin account interest, broker commissions and account usage fees paid over the current tax year.
Although long-term capital gains tax rates are more favorable than short-term capital gains tax rates, few day traders qualify. Unfortunately, short-term capital gains tax is comparative to ordinary income tax. For the 2010 tax year, day traders paid marginal tax rates ranging from 10 percent to 35 percent.
On the other hand, day traders who have a retirement portfolio that is not related to their primary business can qualify for lower tax rates, under the condition that they hold onto these assets for at least a year.
Day trading can merely start as a hobby but quickly develop into a profitable adrenaline pumping business. However, there are critical day trading laws and regulations in place that you may be required to follow.
Your brokerage firm likely has an additional set of requirements and guidelines that may even exceed the restrictions proposed and set forth by Securities and Exchange Commission (SEC), the National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE).
Additionally, always consult a tax professional to file accurate and timely tax returns that maximize your gains. For more trading secrets and how to pick the best tech stocks, subscribe to Nova-X Report.