by Amanda Harvey
Pattern day trading is a term which describes the activity of a trader who executes at least four day trades on the same security within a five-business-day period. This means buying and then selling, or selling short and then buying, the same security again within a single business day. This definition applies to trading all securities, including stocks and options.
The other criteria for being deemed a pattern-day-trader is that the day trades executed account for at least six-percent of the trader’s total activity during the aforementioned five-day period.
It is particularly relevant whether or not a trader is classified as a pattern-day-trader, as this type of trading attracts very specific rules and regulations. The organization that regulates pattern day trading is the Financial Industry Regulatory Authority Incorporated (FINRA), which in turn is under the jurisdiction of the Securities and Exchange Commission (SEC). A trader will only be officially classed as a pattern-day-trader and bound by the relevant rules if they are trading on a margin account.
A trader conducting trading similar to that of a pattern-day-trader, but using a cash account rather than a margin account, must comply with separate rules applying to cash trading accounts.
What Are the Rules for Pattern Day Trading?
One of the most important rules imposed on pattern day trading is that a minimum equity balance of $25 000USD must be maintained in a margin trading account. If the balance of equity in the account falls below the minimum, a margin call is given, which means that the trader must deposit either cash or marginable equities to the account to restore the balance to the minimum. A trader is allowed a period of five business days in which to deposit the amount required to meet the margin call. Until the minimum equity level has been restored, the trader will not be permitted to conduct day trading. If the margin call is not met, the brokerage will restrict the day trading ‘buying power’ which is the primary advantage of pattern day trading.
Once a trader has been given the classification of “pattern-day-trader,” by complying with the basic requirements of making more than four day trades in five business days, and having a margin account with a minimum balance of $25 000, this label takes time to be removed. In order to no longer be classed as a pattern-day- trader, a period of three months must elapse with no day trades being executed before the trader is free to trade outside of the restrictions incurred in this category.
A trader may wish to be classed as a pattern-day-trader in order to take advantage of the increased leverage that comes with the title, and may request that they be given the status without waiting five business days. A brokerage may confer the pattern day trading designation on an individual whom they have reason to believe intends to conduct this type of trading.
Benefits of Pattern Day Trading
The most obvious advantage of this type of trading comes from what is known as buying power. Buying power refers to the increased access to leverage offered by a pattern day trading account. The standard ratio for leverage in a day trading account is 2:1 which means typically a trader can purchase securities worth twice as much as the value in their account above their margin requirement. However, a pattern-day-trader can access leverage of 4:1 meaning that they can make investments worth four times the excess equity value that is in their account. This greater leverage allows a trader to benefit from returns four times greater than if they had used only their own capital. The reverse is also true, though, in that by purchasing investments with more than just their own trading capital, they also taking a greater risk.
Some other advantages of pattern-day-trading, or in fact any type of day trading, come from the benefit of closing all positions before the end of the trading day. These advantages include avoiding overnight gaps and effects of dramatic news reports, having a cash position which allows for a day away from the computer if desired, and even being able to earn interest on the cash in a trading account.
A very clear motivation for day trading is the potential to achieve greater profits by investing and re-investing an amount of capital that could otherwise be tied up in a longer term investment.
Pattern day trading is certainly not suited to everyone, but, for some traders it perfectly suits their trading profile. A large amount of commitment is required, both in terms of time and capital, in order to undertake this style of trading. While increased the leverage available can be very appealing, it is important to realize that this also means greater risk.