One of the most common question day traders ask before they open a trading account is how much starting capital should they put into the initial account. Many don’t know that they can use leverage to increase the amount they can trade.
To start with day trading, you will need to have reasonable amount of savings. Depending on whether you are day trading fulltime, the initial amount of money you require can vary. As mentioned, we typically recommend at least two years of savings from your day job before take the plunge to quit your day job and go into trading.
An amount of $25,000 to $30,000 is the minimum sum if you wish to get around the Pattern Day Trader rule and trade frequently. There are certain brokers that are able to get you around the PDT rule even if you don’t have $25k to spare. Eventually, any broker that you choose should be consistent with the broker criteria that we have explained in the previous chapter.
You should always practice your rules and strategies with paper money before you decide to trade with real money. There are plenty of platforms out there that allow traders to practice. Of course, there is emotion involved during trading that can never be fully experienced just by paper trading. In other words, you might not take paper trading seriously because no real money is involved. Before you put in any amount of real money, new traders need to go in with the mental preparation that all the investment may be lost.
Leverage and Margin
Margin is a loan that is extended by your broker that allows you use the funds of the broker to trade. This effectively allows you to trade larger quantities and potentially make more money with only a little of your own money. Of course, this borrowed money does not come free and has to be paid back with interest. If you are a day trader and always close out your position before market closes, then you should not incur any interest.
Leverage describes the amount of money that you can borrow from the broker. For example, a 5:1 leverage allows you to buy 5 times the number of shares that you can otherwise afford. If you have $1000 in your trading account, a 5:1 leverage offered by the broker will allow you to purchase $5,000 worth of shares.
Of course, margins and leverages are subjective to the conditions of the broker. Not all stocks are available for margin. Typically, higher risk stocks such as penny stocks are less commonly available for borrow by most brokers.
Trading on leverage has the potential for large returns relative to the amount of money you originally put in. Similarly, it also exposes the trader to the possibility large losses. This is the inherent risk that margins carry with them and this is also the reason why if you are trading on leverage, you need to be very clear about what your trading plan is and rules to follow. If you allow your emotions to take over your trading, the consequences can be disastrous!
In the next chapter, we will be going through how exactly you should form your trading plan to mitigate such risks.