September 8th, 2019

The Hurdles Of Day Trading

For those who spend significant time researching stocks day in and day out there is a natural tendency to look towards the idea of day trading as a way to increase profits and decrease loses when the direction of a stock or the overall market seems crystal clear. While no one knows for certain what will happen in the future, you can always use the tools of statistics to diversify your picks and increase your odds of a positive outcome 15 minutes, one hour or four hours into the future. If you find yourself in this situation what should you do?

In these situations, there are actually three main reasons why day trading might not be the right approach even IF you feel like you know the immediate direction of the market well enough to profit.

First, let’s start with the Financial Industry Regulatory Authority (FINRA) definition of day trading which involves buying and selling a single security in one trading session. Two of the three hurdles of day trading described below are regulatory constructions set up by FINRA itself to limit the number of traders who can legally participate in day trading.

The Minimum Required Account Size

FINRA has set the requirement that anyone day trading securities must keep $25,000 value in their brokerage account to actively day trade. If your brokerage account falls below this value, you must add funds to get it above the threshold.

In reality you can trade three times in a five-day window in an account below $25,000 in value, but it is not advisable. Once you are labeled as a pattern day trader with an account value less than $25,000, your account will be locked and you will not be able to trade for 90 days.

Free Rider Violations

Even more limiting that the minimum brokerage requirement is the free rider settlement rule which states you cannot sell a security until the funds used to purchase that security have settled which usually takes T+2 days. This means if you sell a security on Tuesday the funds from that trade will be “settled” until Thursday. So, if you sell stock "X" on Tuesday, buy stock "Y" 30 minutes later using the funds from the sale of stock "X", you will not be able to sell stock "Y" until Thursday at the earliest.

This free rider rule prevents day traders from bouncing into and out of securities using the funds of previous sales. To overcome this rule day traders must keep a minimum balance in settled funds (cash) which creates other problems as mentioned below.

Exiting Your Positions At The End Of the Day

Day traders often feel like time in the market works against their strategy of quickly moving around different trades. Many firms claim to completely exit the market every night and go all into cash to avoid any surprises in after-hours.

While this might seem logical in practice the numbers often tell a different story. Take for example the pattern of the market so far in 2019. Nearly 70% of all the S&P 500 gains in 2019 have occurred after hours. This is a very large number. As a day trader exiting the market every night you would have to overcome this huge percentage during normal hours just to beat the market.

So, with all these hurdles is day trading ever a smart move. In general, I would say no. However, there might be certain situations when it makes sense. Say you are depositing additional funds into your account (settled funds). As you deposit these funds you see a security or group of securities you feel could be mathematically day traded successfully. Assuming you have not done more than two day-trades in the last five days, executing this move might work but would only be advisable assuming your day trading math is solid.

Aside from this very limited case, day trading is extremely risky and is usually not worth the hassle.