Believe it or not, you can significantly enhance your trading returns when using leverage if you have access to day trading buying power.
Leverage is the use of borrowed capital to enhance your trading return. Understanding leverage and how much you can buy, or sell should be incorporated into your day trading strategy.
As you can imagine, the regulatory climate over the years has created rules that limit access to day trading leverage. The U.S. stock exchanges have created a rule to protect the retail investor which requires a minimum account size to benefit from day trade buying power.
While trading using leverage can generate enhance returns, it is a double edge sword and can increase the amount that you lose.
What is a Margin Account?
To benefit from day trading buying power, you need to open a margin account. This is an account set up by your broker where you borrow capital to purchase shares. You cannot take the borrowed money out of your account; it is strictly used to buy and sell shares.
The collateral your broker uses for the borrowed capital in your account are the shares that you have in your portfolio.
When you open a margin account, your broker will provide you with leverage. Leverage allows you to purchase (or sell short) shares using only a fraction of the value of the security.
When you have a margin account you need to post a specific amount of capital for each trade. Additionally, the amount you need to have in your account is updated constantly.
Your broker determines how much leverage you can receive based on the size of your account and is typically 2 to 1 for standard margin and 4 to 1 for day trading buying power.
What is Day Trading Buying Power
With a margin account you can qualify for Day Trading Buying Power (DTBP). This refers to the amount of capital that is available to place trades on a specific day. Your Day Trading Buying Power is equal to the excess maintenance margin that is available in your account multiplied by four.
For example, if you have $25,000 of capital in your account, your Day Trading Buying Power is equal to $100,000. While this is the industry standard some brokers will reduce the day trading leverage that is available based their risk tolerance.
Excess maintenance margin is the capital that you have available that is not allocated to a security, when you buy or sell shares.
There are two types of margin that are allocated to securities you hold in your account. Initial margin is the amount of capital you need to post to initially transact a trade.
Maintenance margin is the capital that is allocated to a security if you begin to experience an unrealized loss on a trade.
Day Trading Buying Power Rules
The U.S. stock exchanges have several rules that apply to Day Trading Buying Power. These Include:
- Margin accounts needs to be classified as Pattern Day Trading
- The minimum account size is $25,000
- Margin rules are governed by FINRA
- You cannot Increase your buying power with same-day deposits
The definition of a pattern day trader is an individual or business that executes 4 or more Day Trades within a 5-business day period. If you qualify, you need to have more than $25,000 in your trading account. This pattern will be consistently monitored by your broker.
A day trade is classified as a pair of trades, a buy and a sell, where risk is increased and decreased during the same trading session. If you want to increase your buying power, it can be done accomplished intra-day by reducing your risk.
When you make an additional deposit, the buying power will only increase on the subsequent day.
The Risks of Trading with Margin
You might have heard that trading with margin is a double-edged sword. The fact of the matter is that you can substantially increase the returns with margin, and at the same time you will increase the amount you can lose.
For accounts with assets below $25,000 you are subject to normal margin requirements. Your broker would require 50% of the value of the shares as initial margin. Your excess maintenance margin would initially be the capital in your account minus your initial margin.
The reason your broker will provide you with 4-times that value of your excess maintenance margin for day trading buying power is that the capital in your account only needs to cover your unrealized losses.
If your unrealized losses exceed a specific threshold, your broker will initially generate a margin call. If you do not add more capital to your account, your broker can have the right to liquidate your position at their discretion.
An Example of How Leverage Works
Here is an example. Let’s assume that you have recently deposited $50,000 in a day trading margin account, and this is your first trade. Your broker will provide you with 4-times your excess maintenance margin, and since you do not have any trades in your portfolio you should have access to control $200,000.
Let’s assume you purchase 10,000 shares of XYZ stock at the price of $20 per share. The stock price subsequently rises to $22 per share and you exit your trade. Your gain is $2 * 10,000 or $20,000.
This would provide you with a 40% return on your trade ($20,000 / $50,000). While this outcome is very attractive, leverage can also generate a 40% loss on your trade if the stock price drops to $18 per share and you take your loss.
The key takeaway is that day trading buying power, can significantly increase your returns and should be incorporated into your trading strategy. Your broker provides you with borrowed capital that is collateralized using the securities that you are buying and selling in your account.
The standard day trading buying power for investors that have margin accounts is 4-times that excess maintenance margin in your trading account.
To protect retail investors FINRA has limited this type of leverage to traders who have account value that are greater than $25,000 and are labeled as pattern day traders.
What is also important to remember is that leverage generates significant risks that can be a double-edged sword.