Pattern Day Trading
by Amanda Harvey
Introduction
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.
In Conclusion
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.
Options traders are not successful because they win.
Options traders win because they are successful.
Back to Types of Traders and Trading
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