Margin account rules for day traders: A 101 guide

A margin account is a type of brokerage account that can be used for day trading, which refers to buying and selling the same security on the same day. Day trading comes with significant risks and regulations. If you're considering day trading, this article will cover the margin account rules – and risks – you should be aware of, as well as the circumstances when they might apply.

What is a margin account?

A margin account is a type of brokerage account that allows investors to borrow money from their broker to purchase securities. This is known as margin trading. Unlike cash accounts that require investors to pay for securities in full, margin accounts let investors use the securities in their account as collateral for a loan. Margin traders open themselves up to the potential not only for significant gains but also for magnified losses if things don’t go their way. It’s important to note, too, that margin loans accrue interest, which can eat into any potential gains.

General requirements for margin accounts

To open a margin account, investors need to make an initial deposit. While minimum deposit requirements vary by firm, the Financial Industry Regulatory Authority (FINRA) requires at least $2,000 or the full purchase price of the margin securities a person wants to buy, whichever is less.

Federal regulations also limit the percentage of a security’s purchase price that can be financed with borrowed funds. Under the Federal Reserve Board’s Regulation T, investors can generally borrow up to 50% of the initial cost, although firms may impose stricter limits.

After the purchase, you must also maintain at least 25% of the total market value of the margin securities in your account on an ongoing basis, though many firms require more.

Margin account vs. cash account

To better understand the differences between cash accounts and margin accounts, let’s consider an example. Here’s how a $10,000 stock purchase might work in a cash account versus a margin account.

Let’s say you buy shares of stock for $10,000 using a cash account. If you sell them for $15,000, you’d profit $5,000. That’s a return on investment (ROI) of 50%. What if you sold your shares for $5,000, though? In that case, you’d lose $5,000 for an ROI of -50%.

Now, let’s say you buy the same $10,000 stock using a margin account but borrow half of the investment, or $5,000, from your broker. If you sell the stock for $15,000, you’d repay your broker $5,000 and earn $5,000 gross profit for an ROI of 100%, minus interest and any fees.

If you sold your shares of stock for $5,000, though, you’d repay your broker $5,000 and lose your $5,000 investment for an ROI of -100%, plus interest and any fees.

As this example illustrates, margin accounts can help you earn more while investing less upfront, but they also carry more risk than cash accounts. Not only could you lose your cash investment and the borrowed funds, but you’ll also have to pay interest on the margin loan. An additional risk with margin trading is when a stock price falls significantly, brokerage firms can issue a margin call – forcing you to put up more money to cover the transaction – or even sell your securities without notice.

Day traders: Who’s required to have margin accounts?

A day trade refers to the buying and selling, or selling and buying, of the same security on the same day. For example, an investor might buy shares of a company at 10 a.m. and sell them at 3 p.m. Day trading can also refer to short selling a security and then buying it back. The goal is to profit from the movement of a security’s price throughout a single trading day.

You can day trade with a cash account, but doing it repeatedly could lead to a settlement violation known as freeriding.  Freeriding means you’re buying and selling securities before the funds settle, which means you’re selling securities without fully paying for them in the first place.

Once your day trading activity crosses a certain threshold, you may be identified as a pattern day trader (PDT) by your brokerage firm. This has several implications, including the potential requirement of a margin account.

Who is considered a pattern day trader?

According to FINRA, a PDT is someone who executes at least four day trades in a margin account within five rolling business days, provided those trades account for more than 6% of the investor’s total trading activity during that time. Individual firms, however, can expand on the definition of a PDT.

If you are considering day trading, it’s critical to understand both the general rules of margin accounts and how your specific firm determines PDT status. Not only is margin trading inherently riskier than trading with a regular cash brokerage account, but PDT requirements – including higher account minimums – are far more stringent than those for typical investors.

Margin requirements for PDTs

PDTs are subject to the margin requirements set by their brokerages, which must adhere to the following conditions established by FINRA Rule 4210:

While firms can have their own “house requirements” for PDTs, the minimum equity limit cannot be less than $25,000, and the maximum buying power for equities cannot exceed a ratio of 4:1.

Violating margin account rules: Consequences for day traders

If a PDT’s equity drops below the brokerage firm’s minimum equity requirement, the investor won’t be allowed to day trade until the account’s minimum equity level has been restored. Additionally, if a PDT exceeds the day trading buying power limit, the brokerage firm will issue a margin call, demanding that a certain amount of cash or securities be deposited in the account.

Once a margin call is issued, a PDT has a maximum of five business days to deposit the required amount. During that time, the account will be restricted to a day trading buying power of only two times the maintenance margin excess. If the margin call isn’t met by the deadline, the PDT may face additional restrictions, such as being able to trade only on a cash available basis for 90 days.

How to avoid common margin account violations

To avoid breaking the margin rules as a PDT, check your broker’s minimum equity requirements and buying power limits. Once you understand them, you can ensure your account equity stays above the minimum and that you don’t exceed your buying power. If you don’t want to worry about the margin rules for pattern day trading at all, you’ll need to keep your day trades to a minimum to avoid being flagged as a PDT – which means no more than three day trades in any rolling five-business-day period.

The bottom line

Margin accounts grant traders access to more buying power and day trading, but they also carry more risk and can lead to steep equity requirements. If you’re considering pattern day trading, you’ll need to be prepared to keep at least $25,000 in your margin account, monitor your buying power closely and understand that leverage cuts both ways. While pattern day trading – and margin – can boost your gains, it can also magnify losses.

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