Pattern day trader

Pattern day trader is a term defined by FINRA to describe a stock market trader who executes 4 (or more) day trades in 5 business days in a margin account, provided the number of day trades are more than six percent of the customer's total trading activity for that same five-day period.[1]

As the trader is exposed to the potential risks involved in day trading and potential rewards, it is subject to specific requirements and restrictions.

Basic summary

A FINRA (formerly National Association of Securities Dealers, Inc. or NASD) rule applies to any customer who buys and sells a particular security in the same trading day (day trades), and does this four or more times in any five consecutive business day period; the rule applies to margin accounts, but not to cash accounts. A pattern day trader is subject to special rules. The main rule is that in order to engage in pattern day trading you must maintain an equity balance of at least $25,000 in a margin account. The required minimum equity must be in the account prior to any daytrading activities. Three months must pass without a day trade for a person so classified to lose the restrictions imposed on them. Pursuant to NYSE 432, brokerage firms must maintain a daily record of required margin.

The minimum equity requirement in FINRA Rule 4210 was approved by the Securities and Exchange Commission (SEC) on February 27, 2001 by approving amendments to NASD Rule 2520. [2]

Definition

A pattern day trader is generally defined in FINRA Rule 4210 (Margin Requirements) as any customer who executes four or more round-trip day trades within any five successive business days.[3] FINRA Rule 4210 is substantially similar to New York Stock Exchange Rule 431.[4] If, however, the number of day trades is less than or equal to 6% of the total number of trades that trader has made for that five business day period, the trader will not be considered a pattern day trader and will not be required to meet the criteria for a pattern day trader.[5]

A non-pattern day trader (i.e. someone with only occasional day trades), can become designated a pattern day trader anytime if they meet the above criteria. If the brokerage firm knows, or reasonably believes a client who seeks to open or resume trading in an account will engage in pattern day trading, then the customer may immediately be deemed to be a pattern day trader without waiting five business days.[6]

Round trip

Definition: The purchase and subsequent sale of forementioned purchased (stocks).

Day trading refers to buying then selling or selling short then buying back the same security on the same day.[7] Interpretation for more complex situations may be subject to interpretation by an individual brokerage firm, for example if you buy the same stock in three trades on the same day, and sell them all in one trade, that can be considered 1 day trade[8] or three day trades.[9] If you buy stock in one trade and sell the position in three trades, that is generally considered as one day trade if all trades are done on the same day. Three more day trades in the next four business days will subject your account to restrictions (you can only close existing positions or purchase with available cash up front) for 90 days, or until you deposit $25,000 into your account, whichever comes first. Day trading also applies to trading in option contracts. Forced sales of securities through a margin call count towards the day trading calculation.

Requirements and restrictions

Under the rules of NYSE and Financial Industry Regulatory Authority, a trader who is deemed to be exhibiting a pattern of day trading is subject to the "Pattern Day Trader" rules and restrictions and is treated differently than a trader that holds positions overnight. In order to day trade:[3]

Day trading buying power

The rule provides day trading buying power to up to 4 times a pattern day trader's maintenance margin excess (The excess maintenance margin is the difference of the account equity and the margin requirement. For example, if a trader has $100,000 worth of equities with no margin loan, the leverage ratio is 4:1 meaning that it can buy securities of up to $400,000. If the account has a margin loan, the day trading buying power is equal to four times the difference of the account equity and the current margin requirement.

For day trading in equity securities, the day trading margin requirement shall be 25% of either:

  1. the cost of all day trades made during the day; or
  2. the highest open position during the day.

If a client's day trading margin requirement is to be calculated based on the latter method, the brokerage must maintain adequate time and tick records documenting the sequence in which each day trade is completed. Time and tick information provided by the customer is not acceptable.

Day trading in cash accounts

The Pattern Day Trading rule regulates the use of margin and is defined only for margin accounts. Cash accounts, by definition, do not borrow on margin, so day trading is subject to separate rules regarding Cash Accounts. Cash account holders may still engage in certain day trades, as long as the activity does not result in free riding, which is the sale of securities bought with unsettled funds. An instance of free-riding will cause a cash account to be restricted for 90 days to purchasing securities with cash up front. Under Regulation T, brokers must “freeze” an investor’s account for 90 days if they sell securities that have not been fully paid (paid for with unavailable funds). During this 90-day period, the investor must fully pay for any purchase on the date of the trade.[10]

History

Requirements for the entry of day trading orders by means of "pattern day trader" amendments: On February 27, 2001, the Securities and Exchange Commission (SEC) approved amendments to NASD Rule 2520 relating to margin requirements for day traders. The NASD amendments to Rule 2520 became effective on September 28, 2001, while the NYSE amendments to Rule 431, which are substantially similar, information memo from NYSE became effective August 27, 2001. Effective December 2, 2010, the NASD rule was revised, renumbered and incorporated into the FINRA Rule book. FINRA was formed by the merger of NASD Regulation and NYSE Regulation in July 2007. The SEC approved the formation of FINRA as a new SRO to be a successor to NASD Regulation and the enforcement and arbitration functions of the New York Stock Exchange. The Financial Industry Regulatory Authority is also known as FINRA.

Rationale

While all investments have some inherent level of risk, day trading is considered by the SEC to have significantly higher risk than buy and hold strategies. The Securities and Exchange Commission (SEC) approved amendments to Self-regulatory organization rules to address the intra-day risks associated with customers conducting day trading. The rule amendments require that equity and maintenance margin be deposited and maintained in customer accounts that engage in a pattern of day trading in amounts sufficient to support the risks associated with such trading activities.

The SEC believes that people whose account equity is less than $25,000 may represent less-sophisticated traders, who may be less able to handle the losses that may be associated with day trades. This is along a similar line of reasoning that hedge fund investors typically must have a net worth in excess of $1 million. In other words, the SEC uses the account size of the trader as a measure of the sophistication of the trader. This rule essentially works to restrict less sophisticated traders from day trading by disabling the traders ability to continue to engage in day trading activities unless they have sufficient assets on deposit in the account.

One argument made by opponents of the rule is that the requirement is "governmental paternalism" and anti-competitive in a sense that it puts the government in the position of protecting investors/traders from themselves thus hindering the ideals of the free markets. Consequently, it is also seen to obstruct the efficiency of markets by unfairly forcing small retail investors to use Bulge bracket firms to invest/trade on their behalf thereby protecting the commissions Bulge bracket firms earn on their retail businesses.

Another argument made by opponents, is that the rule may, in some circumstances, increase a trader's risk. For example, a trader may use 3 day trades, and then enter a fourth position to hold overnight. If unexpected news causes the security to rapidly decrease in price, the trader is presented with two choices. One choice would be to continue to hold the stock overnight, and risk a large loss of capital. The other choice would be to close the position, protecting his capital, and (perhaps inappropriately) fall under the day-trading rule, as this would now be a 4th day trade within the period. Of course, if the trader is aware of this well-known rule, he should not open the 4th position unless he or she intends to hold it overnight. However, even trades made within the three trade limit (the 4th being the one that would send the trader over the Pattern Day Trader threshold) are arguably going to involve higher risk, as the trader has an incentive to hold longer than he or she might if they were afforded the freedom to exit a position and reenter at a later time. In this sense, a strong argument can be made that the rule (inadvertently) increases the trader's likelihood of incurring extra risk to make his trades "fit" within his or her allotted three-day trades per 5 days unless the investor has substantial capital.

The rule may also adversely affect position traders by preventing them from setting stops on the first day they enter positions. For example, a position trader may take four positions in four different stocks. To protect his capital, he may set stop orders on each position. Then if there is unexpected news that adversely affects the entire market, and all the stocks he has taken positions in rapidly decline in price, triggering the stop orders, the rule is triggered, as four day trades have occurred. Therefore, the trader must choose between not diversifying and entering no more than three new positions on any given day (limiting the diversification, which inherently increases their risk of losses) or choose to pass on setting stop orders to avoid the above scenario. Such a decision may also increase the risk to higher levels than it would be present if the four trade rule were not being imposed.

References

  1. ↑ "SEC explanation of Pattern Day Trader".
  2. ↑ "FINRA Notice: SEC Approves Proposed Rule Change Relating To Day-Trading Margin Requirements" (PDF).
  3. 1 2 "FINRA Rule 4210 Margin Requirements".
  4. ↑ "NYSE Rule 4210 incorporated into the FINRA Rule Book".
  5. ↑ "Amendments to Rule 431 ("MARGIN REQUIREMENTS") Regarding "Day Trading"" (PDF).
  6. ↑ "Margin Rules for Day Trading" (PDF).
  7. ↑ "Day Trading Margin Requirements: Know the Rules".
  8. ↑ "Trade King definition of Counting Day Trades".
  9. ↑ "ETrade definition of pattern day trading".
  10. ↑ "SEC Office of Investor Education and Advocacy, "Trading in Cash Accounts: Beware of the 90-Day Freeze" (PDF).
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