Pattern day trader: Difference between revisions

Revision as of 03:57, 8 October 2020

Latest revision as of 22:59, 12 February 2025

(10 intermediate revisions by 8 users not shown)

Line 1:

{{Short description|Type of stock trader}}

{{Use American English|date=June 2020}}

{{Use mdy dates|date=June 2020}}

{{howto|date=April 2024}}

In the [[United States]], a '''pattern day trader''' is a [[Financial Industry Regulatory Authority]] (FINRA) designation for a [[stock trader]] who executes four or more [[Day trading|day trades]] in five 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.<ref>{{cite web|title=Pattern Day Trader|url=https://www.sec.gov/fast-answers/answerspatterndaytraderhtm.html|website=SEC.gov|publisher=[[Securities and Exchange Commission]]|date=February 10, 2011|accessdate=June 1, 2020}}</ref>

A FINRA 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 day trading 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 firm]]s 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.<ref name="ref2" />

Line 11 ⟶ 13:

A pattern day trader is generally defined in FINRA Rule 4210 ([[Margin (finance)|Margin]] Requirements) as any customer who executes four or more round-trip day trades within any five successive business days.<ref name="FINRA 4210" /> FINRA Rule 4210 is substantially similar to New York Stock Exchange Rule 431.<ref name="ref4" /> If, however, the number of day trades is less than or equal to 6% of the total number of trades that [[Trader (finance)|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.<ref name="ref5" />

A non-pattern day trader (i.e. someone with only occasional day trades), can become designated a pattern day trader anytime if hethey meetsmeet 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.<ref name="ref6" />

==Round trip==

A '''round trip''' is the purchaseopening and subsequent saleclosing of equitiesa security position. Whether you buy or sell to open, when you close the position, you’ve completed a round trip.

Day trading refers to buying and then selling or selling short and then buying back the same security on the same day.<ref name="ref7" /> 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 one day trade,<ref name="ref8" /> or three day trades.<ref name="ref9" /> 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 enough to have $25,000 in 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.

Line 28 ⟶ 30:

==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 (stock market)|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 hethe or sheinvestor sells securities that have not been fully paid (i.e. paid for with unavailable funds). During this 90-day period, the investor must fully pay for any purchase on the date of the trade.<ref name="ref10" />

==Rationale==

{{Multiple issues|section=yes|

{{POV section|date=December 2019}}

{{Unreferenced section|date=June 2020}}

}}

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 intraday 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 poorer traders from day trading by disabling the trader's 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.

On the other hand, some argue that it is problematic not because it is some sort of unfair over-regulatory attack on the "free market," but because it is a rule that shuts out the vast majority of the American public from taking advantage of an excellent way to grow wealth. It does so by imposing a "poverty tax" on those who do not have $25,000 available.

Another argument made by opponents, is that the rule may, in some circumstances, increase a trader's risk. For example, a trader may use three 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==