Subject: Trading - Day Trading, Margin and Free Ride Rules

Last-Revised: 27 Sep 2010
Contributed-By: Karl Denninger (karl at mcs.com), Timothy M. Steff (tim at navillus.com), Casey Nicholson (caseynicholson at mac.com)

This article discusses the basic mechanics of day trading, the free-ride regulations, and explains how traders use margin accounts to avoid violating those free-ride regulations. Day trading is the term applied to people who buy and sell stocks through the course of a day, rarely holding a stock overnight. You might be wondering just what a free ride is, why it's prohibited by market regulators, and how day traders cope. Also see the FAQ article that discusses margin regulations.

When trading stocks, a "free ride" describes the case when you buy a security at 10 and sell it an hour or a day later at 12, without having the free funds to cover the settlement of the trade at 10. Any purchase of securities takes three business days to settle funds through the exchange and the brokerage houses involved. Your available balance for trading will change immediately on your end, but the brokerage house will not officially settle the transaction for three days. Free-riding, then, means that you are selling stock that you don't yet officially own. This activity is prohibited by the exchanges; for example, NYSE Rule 431 forbids member organizations

from allowing their customers to day-trade in cash accounts. If you trade in a cash account, you must be able to settle the trade, even if you would take the profit from it in the same day.

Example:
Buy 1,000 XYZ at $10 on Monday
Requires $10,000 free cash available to settle the trade.
Sell 1,000 XYZ at $15 on Tuesday
You're a lucky dog, one day later you are up 50% and you will get $15,000 from the sale. But you still must be able to settle the original purchase without the proceeds of the sale for the first trade to be legitimate. If you cannot settle the trade, it's a free ride.

Being able to settle the trade means that you either have sufficient cash in your account to pay for the shares, or sufficient reserve in your margin account to cover the shares.

Here's how the regulation affects trades in cash account. In a cash account you can spend a dollar only once until the trade settles. That is to say if you start the day in cash, you can buy stock and sell that stock -- and then are done trading that piece of your account until the settlement date passes. If you start in stock you can sell it, spend the cash for another position, sell that position and then again must wait for settlement before spending that amount again. For instance, if you have a $20,000 cash account, you could trade $5,000 one day, $5,000 the next and another $10,000 the next. In doing so you'd have to wait three business days before trading each amount again. If you entered a position that costs the full $20,000 (or near it), you'd have to wait a full three days before trading that $20,000 (plus or minus your earnings) once again.

These rules on free rides should in no way be interpreted as a prohibition on "day trading" (i.e., trading very rapidly in and out of a stock). You can trade as much as you want, provided that you can settle the trade.

How do day traders make sure they can always settle their trades and avoid running afoul of the free-ride regulations? The short answer is that day traders must use a margin account with a substantial cash balance, and must fund all trades from margin, never from cash. They leave their cash position untouched, which means they do not actually exercise any leverage on their account. A day-trader only carries a margin balance that is equal to, or less than, their cash balance in order to comply with the free-ride regulations. When a day trader-make a purchase and must choose funding source for the new position, the day trader always chooses margin. This ensures the settlement is covered three days later, no matter what happens to the stock price over that time, and no violation of the free-ride rules can happen.

Here's an example of how a violation can happen when a stock price falls. Suppose you have a very small account with $475 cash in it. Your margin buying power is the same as your equity balance, that's $475. You choose to buy one share of BigWebSearchCompany at $475. Overnight the market falls and BigWebSearchCo closes at $450. If you bought the share on margin, you used the margin funds and retained the full amount of cash that you originally paid for the share. So you have the cash for the settlement three days later, and the price drop has not caused any rule violation. What happens if you purchase the BWSC share in cash and it falls in price? Your equity has dropped, and remember that your margin buying power always matches your equity. So, take the same example. You buy BWSC at $475 with your own cash (you chose cash as the funding source). That leaves you with $475 in margin buying power to fund the settlement, so far so good. The next day the price drops to $450. Your new margin buying power is $450. But you need $475 to fund the settlement, and you don't have it! Thus, you can violate the free-ride rules in a margin account if you're not careful.

If you use margin, keep in mind that your broker is allowed to delay the credit for your sale until settlement if they so choose, keeping you from using those funds for three days. If they are a market-making firm or are selling their order flow they will likely obstruct your intra-day and short term trading since it cuts into their bottom line. To day-trade using a margin account, you need a broker that uses NYSE day-trading rules for margin. Chances are your broker will have no idea what you are talking about if you ask about this.

And don't forget about margin interest. When you use margin, which means borrowing money from your brokerage firm, they will charge you interest on any position held overnight (which usually means after 4:00 PM U.S. Eastern time). Day traders exit positions by the end of the normal market day in order to avoid margin interest accrual.

Unlike stocks, options settle the next day, which is both good and bad. Option trading basically requires that the funds be there before you place the trade, unless you like wiring funds around (and paying for the privilege of doing so).

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