Investors can use many different strategies to trade stocks. Some people buy assets and hold them for the long term, others make frequent trades, buying and selling stocks daily. Let’s learn about how day traders can face higher risks than other investors and interact with their brokers quite differently as well as about the rules for pattern day traders.
Definition and Example of a Pattern Day Trader
The Financial Industry Regulatory Authority (FINRA) defines a pattern day trader as someone who executes four or more day trades within a five-business-day period or someone who “has a reasonable basis to believe” that they will execute such trades. For example, if you buy 10 shares of XYZ in the morning, then sell those shares in the afternoon, you’ve executed a day trade. If over the next five business days, you execute a total of four or more day trades, you’d be considered a pattern day trader.
How Does Pattern Day Trading Work?
Pattern day traders typically make frequent transactions, buying and selling stocks, options, and other securities through the trading day. Often, these traders are looking to earn a profit from small shifts in a security’s prices and use margin to increase their potential gains when compared to their assets. Because pattern day trading is different from typical investing and can involve additional risks, there are special rules that pattern day traders must follow.
Pattern Day Trader vs. Other Investors
The primary difference between day traders and other investors is how they aim to profit from the market and the risks they’re willing to accept. Day traders focus on the short term and look to make money by quickly buying and selling stocks as they fluctuate in price, whereas other investors have a more long-term outlook. Buy-and-hold investors try to buy stocks they believe will steadily appreciate in value through ups and downs.
Pros Explained
Potential for high profits: Skilled day traders can produce a return that earns them a living. However, it can take many months to develop a successful strategy for reliable returns. Short-term outlook: Day trading is about short-term price movements and taking advantage of fluctuations. You don’t need to think about how a security will perform in a month, a year, or even a decade. Margin increases potential gains: Day traders use margin accounts, which let them borrow money to invest. So, for example, if you have $30,000 and use $30,000 in margin, you can invest $60,000, which doubles your potential profit.
Cons Explained
High risk: Day trading is risky. One bad trade can cause significant losses and result in a margin call.Margin increases potential losses: When you borrow money to buy stocks, that increases your potential losses. In some cases, you could wind up losing more money than you have, forcing you to repay a debt to your broker.Can require more time and effort than long-term investing: Day traders can spend the entire day following the market and trying to find the perfect times to buy and sell.
Is Pattern Day Trading Worth It?
Pattern day trading is a high-risk, stressful way to try to profit from the stock market. However, it offers the potential for significant returns. Some traders even pursue day trading as their profession.
What It Means for Individual Investors
Day trading isn’t ideal for typical individual investors. It can be very risky and requires significant amounts of time and research to make successful trades. Most investors who are aiming to build their portfolios toward long-term goals like retirement can benefit more from a passive investing strategy of holding a diversified portfolio of stocks, bonds, and other securities for longer terms. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
