Pattern day trader
Encyclopedia
Pattern day trader is a term defined by the U.S. Securities and Exchange Commission 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. As the trader
is exposed to the danger of day trading
and intraday risks and potential rewards, it is subject to specific requirements and restrictions.
Rule 2520, the minimum equity requirement rule was passed on February 27, 2001 by the Securities and Exchange Commission (SEC) approving amendments to National Association of Securities Dealers, Inc. (NASD).
Requirement) as any customer who executes 4 or more round-trip day trades within any 5 successive business days.
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 they will not be required to meet the criteria for a pattern day trader.
A non-pattern day trader (i.e. someone with only occasional day trading
), can become designated a pattern day trader anytime if they meet the above criteria.
If the brokerage
knows, or reasonably believes a client who seeks to open or resume an account will engage in pattern day trading, then the customer must immediately be considered a pattern day trader without waiting 5 business days.
Source: Information Memo of Amendments to Rule 431 ("Margin Requirements") Regarding "Day Trading"
If you buy the same stock, at 3 different times in the same day, and close all of that same stock in one trade, that will be considered 1 day trades. Three more day trades in the next 4 business days will freeze your account (you can only close existing positions) for 90 days, or until you get $25,000 cash into your account, whichever comes first. This also applies to options.
, a trader
who is deemed to be exhibiting a pattern of day trading will be subject to the "Pattern Day Trader" laws and restrictions, which is treated differently from a normal trader
. In order to day trade:
buying power to up to 4 times a pattern day trader's maintenance margin
excess. For example, if a trader
has $100,000 worth of equities, the leverage
ratio is 4:1 meaning that it can buy securities of up to $400,000.
For day trading
in equity securities, the day trading margin requirement shall be 25% of either:
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.
further restrict the entry by means of "pattern day trader" amendments. On February 27, 2001, the Securities and Exchange Commission (SEC) approved amendments to National Association of Securities Dealers, Inc. (NASD) Rule 2520 relating to margin
requirements for day traders. The NASD amendments to Rule 2520 become 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.
is considered by the SEC to have significantly high risk. The Securities and Exchange Commission (SEC) makes new amendments to address the intraday risks associated with day trading in customer accounts. The 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.
In addition, the SEC believes that people whose account sizes are less than $25,000 may represent less sophisticated traders, who may be more prone to being misled by advisory brokers and/or tipping agencies. 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.
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 equity 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 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 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.
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 takes 4 different positions in 4 different stocks. To protect his capital, he sets stop losses on each position. There is then unexpected news that adversely affects the entire market, and all the stocks he has taken positions in rapidly decline in price, triggering the stop losses. The rule is now triggered, as 4 day trades have occurred. Therefore, the trader must choose between not diversifying and entering no more than 3 new positions on any given day (limiting their diversification, which inherently increases their risk of losses) or choose to pass on setting stops due to fear of the above scenario, a decision which also increases the risks to higher levels than it would be present if the four trade rule were not being imposed.
Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
trader
Stock trader
A stock trader or a stock investor is an individual or firm who buys and sells stocks in the financial markets. Many stock traders will trade bonds as well...
who executes 4 (or more) day trades
Day trading
Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
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. As the trader
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
is exposed to the danger of day trading
Day trading
Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
and intraday risks and potential rewards, it is subject to specific requirements and restrictions.
Basic Summary
A FINRA (NASD) rule that 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, 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. Brokerage firms are not required under the rule to monitor the minimum equity requirements on an intra-day basis. Three months must pass without a day trade for a person so classified to lose the restrictions imposed on them.Rule 2520, the minimum equity requirement rule was passed on February 27, 2001 by the Securities and Exchange Commission (SEC) approving amendments to National Association of Securities Dealers, Inc. (NASD).
Definition
A pattern day trader is defined in Exchange Rule 431 (MarginMargin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
Requirement) as any customer who executes 4 or more round-trip day trades within any 5 successive business days.
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 they will not be required to meet the criteria for a pattern day trader.
A non-pattern day trader (i.e. someone with only occasional day trading
Day trading
Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
), can become designated a pattern day trader anytime if they meet the above criteria.
If the brokerage
Stock broker
A stock broker or stockbroker is a regulated professional broker who buys and sells shares and other securities through market makers or Agency Only Firms on behalf of investors...
knows, or reasonably believes a client who seeks to open or resume an account will engage in pattern day trading, then the customer must immediately be considered a pattern day trader without waiting 5 business days.
Source: Information Memo of Amendments to Rule 431 ("Margin Requirements") Regarding "Day Trading"
Round Trip
Defined: The successful purchase and subsequent sale of forementioned purchased (stocks).If you buy the same stock, at 3 different times in the same day, and close all of that same stock in one trade, that will be considered 1 day trades. Three more day trades in the next 4 business days will freeze your account (you can only close existing positions) for 90 days, or until you get $25,000 cash into your account, whichever comes first. This also applies to options.
Requirements and Restrictions
Under the rules of NYSE and Financial Industry Regulatory AuthorityFinancial Industry Regulatory Authority
In the United States, the Financial Industry Regulatory Authority, Inc., or FINRA, is a private corporation that acts as a self-regulatory organization . FINRA is the successor to the National Association of Securities Dealers, Inc. ...
, a trader
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
who is deemed to be exhibiting a pattern of day trading will be subject to the "Pattern Day Trader" laws and restrictions, which is treated differently from a normal trader
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
. In order to day trade:
- Day trading minimum equity: the account must maintain at least US$25,000 worth of equityOwnership equityIn accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
. - Margin call to meet minimum equity: A day trading minimum equity request is called when the pattern daytrader account falls below US$25,000. This minimum must be restored by means of cash deposit or other marginable equities.
- Deadline to meet calls: Pattern day traders are allowed to deposit funds within 5 business days to meet the marginMargin (finance)In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
call - Non-withdrawal deposit requirement: This minimum equityOwnership equityIn accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
or deposits of funds must remain in the account and cannot be withdrawn for at least 2 business days. - Cross guarantees are prohibited: Pattern day traders are prohibited from utilizing cross guarantees to meet day trading marginMargin (finance)In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
calls or to meet minimum equity requirements. Each day tradingDay tradingDay trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
account is now required to meet all marginMargin (finance)In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
requirements independently, using only the funds available in the account.
- Deadline to meet calls: Pattern day traders are allowed to deposit funds within 5 business days to meet the margin
- Restrictions on accounts with unmet calls: if the call is not met, the account's day tradingDay tradingDay trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
buying power will be frozen for 90 days or until day tradingDay tradingDay trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
minimum equity marginMargin (finance)In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
call is met again.
Day Trading Buying Power
The rule increases day tradingDay trading
Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
buying power to up to 4 times a pattern day trader's maintenance margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
excess. For example, if a trader
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
has $100,000 worth of equities, the leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
ratio is 4:1 meaning that it can buy securities of up to $400,000.
For day trading
Day trading
Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
in equity securities, the day trading margin requirement shall be 25% of either:
- the cost of all day trades made during the day; or
- the highest open position during the day.
If a client's day trading
Day trading
Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
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.
History
NASDAQNASDAQ
The NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations". It is the second-largest stock exchange by market capitalization in the world, after the New York Stock Exchange. As of...
further restrict the entry by means of "pattern day trader" amendments. On February 27, 2001, the Securities and Exchange Commission (SEC) approved amendments to National Association of Securities Dealers, Inc. (NASD) Rule 2520 relating to margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
requirements for day traders. The NASD amendments to Rule 2520 become 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.
Rationale
While all investments have some inherent level of risk, day tradingDay trading
Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
is considered by the SEC to have significantly high risk. The Securities and Exchange Commission (SEC) makes new amendments to address the intraday risks associated with day trading in customer accounts. The 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.
In addition, the SEC believes that people whose account sizes are less than $25,000 may represent less sophisticated traders, who may be more prone to being misled by advisory brokers and/or tipping agencies. This is along a similar line of reasoning that hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
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.
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
Bulge bracket
The bulge bracket comprises the "big banks," the world's largest and most profitable multi-national investment banks.- Technical meaning :The term 'bulge bracket' refers to the first group of investment banks listed on the "tombstone" notifying the public of a financial transaction or deal...
firms to invest/trade on their behalf thereby protecting the commissions Bulge bracket
Bulge bracket
The bulge bracket comprises the "big banks," the world's largest and most profitable multi-national investment banks.- Technical meaning :The term 'bulge bracket' refers to the first group of investment banks listed on the "tombstone" notifying the public of a financial transaction or deal...
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 equity 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 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 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.
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 takes 4 different positions in 4 different stocks. To protect his capital, he sets stop losses on each position. There is then unexpected news that adversely affects the entire market, and all the stocks he has taken positions in rapidly decline in price, triggering the stop losses. The rule is now triggered, as 4 day trades have occurred. Therefore, the trader must choose between not diversifying and entering no more than 3 new positions on any given day (limiting their diversification, which inherently increases their risk of losses) or choose to pass on setting stops due to fear of the above scenario, a decision which also increases the risks to higher levels than it would be present if the four trade rule were not being imposed.