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Day Trading Margin Rules - Pattern Day Trading

Definition of pattern day trading and margin rules for day trading

What is a Pattern Day Trader?

In 2001, Day Trading Rules changed significantly based on how frequently a stock trader executes a day trade.

If a trader exceeds a certain number of day trades within a limited period of time, the trader's brokerage firm is required to mark the account a Pattern Day Trader (PDT). Certain restrictions apply to these type of accounts.

A Pattern Day Trader is one who makes more than 3 day trades within a rolling 5 business day period. The first time this trade limit is exceeded we permanently designates it as a Pattern Day Trading account. If a trader makes only 3 day trades or less during this 5 day period, he or she is NOT considered a Pattern Day Trader.

There are pros and cons to having a Pattern Day Trade account. Because of this, a trader may elect to be labeled as a Pattern Day Trader before exceeding the 3 day trade limit. Since the number of trades is such an important factor, it is critical for the online trader to understand precisely what kind of activity constitutes a Day Trade.

What is considered a Day Trade?

A Day Trade consists of 2 off setting transactions which occurred in the SAME security on the SAME day. The order of these transactions must be opening followed by closing. This sequence must be maintained to meet the definition of a Day Trade. The trading session in which these trades occurred is not important. Pre and post market trades are treated the same as regular session trades. With regard to time, all that is relevant is that the trades occurred on the same day and that positions are not being held overnight.

The Number of Day Trades is Important

The quantity of shares traded or number of orders can complicate the definition. The total number of day trades on a given day in a specific security is determined by the lesser number of opening or closing transactions. Here are a few examples to make this more clear. (All of these examples hold true irrespective of opening with a long or short position.)

If a trader opens a stock position with one order of 800 shares and exits the same position with two 400 share orders, these three trades are grouped together as one day trade.

If a trader opens a position with two orders of 400 shares, the trader has a position of 800 shares. If this position is liquidated with one order of 800 shares, this series of orders is also considered as one day trade.

However...let's assume the same trader again creates a position with two orders of 400 shares. Even though a similar holding of 800 shares is created, two day trades will result if the trader closes out with two oders of 400 shares. (Two transactions on each side)

If any of the orders mentioned above are filled in multiple transactions, this alone does not affect the number of day trades taken. For example a trader placing an order to close a position of 600 shares may receive confirmations on 200 and 300 shares with 100 shares still open. All 600 shares will be considered one transaction, provided the trader does not modify the remaining order balance of 100 shares. If the trader makes changes to the partially filled order, it will be classified as a brand new order. If this new order becomes executed it will create an additional day trade.

When the Number Exceeds 3 Day Trades

If a stock trader makes 4 or more day trades in a rolling 5 business day period, the account will be labeled immediately as a Pattern Day Trade account. Certain limitations will then be applied based on the account equity. (Account equity is the amount of cash that would exist if every position in the account was closed.)

The most important one is the requirement to maintain a minimum account equity of $25,000. If the trader is able to maintain this minimum, the trader may day trade as frequently as desired. However if the trader makes more than 3 day trades in this period without maintaining the minimum balance, the account will become restricted from day trading and all positions must be held overnight. There's no limit to the number of trades if you hold the positions overnight.

 


Pattern Day Trader - by the U.S. Securities and Exchange Commission

FINRA rules define a "pattern day trader" as any customer who executes four or more "day trades" within five business days, provided that the number of day trades represents more than six percent of the customer's total trades in the margin account for that same five business day period. This rule represents a minimum requirement, and some broker-dealers use a slightly broader definition in determining whether a customer qualifies as a "pattern day trader." Customers should contact their brokerage firms to determine whether their trading activities will cause them to be designated as pattern day traders.

A broker-dealer may also designate a customer as a "pattern day trader" if it "knows or has a reasonable basis to believe" that a customer will engage in pattern day trading. For example, if a customer's broker-dealer provided day trading training to such customer before opening the account, the broker-dealer could designate that customer as a "pattern day trader."

Under FINRA rules, customers who are deemed "pattern day traders" must have at least $25,000 in their accounts and can only trade in margin accounts. For more information on pattern day traders and related FINRA margin rules, please read the SEC staff's investor bulletin "Margin Rules for Day Trading."


 

Increased Leverage: A Possible Benefit for Pattern Day Trade Accounts

If a trader can maintain the minimum balance requirement of $25,000, there are certain benefits for this type of account. Increased access to margin and therefore increased leverage can be one of them.

For non pattern day trading accounts with standard access to margin, traders may hold positions in value of up to twice the amount of cash in their account. For example if the account has $30,000 in cash, the trader can buy up to $60,000 worth of stock. The trader uses the $30,000 and the brokerage firm lends the remaining $30,000 to the trader on margin and charges interest on the loan.

Pattern Day Trade accounts will have access to approximately twice the standard amount of margin when trading stocks. This is known as Day Trading Buying Power and the amount is determined at the beginning of each trading day. When trading stock, Day Trading Buying Power is four times the cash value instead of the normal margin amount cited above. In the previous example, the trader would be able to trade up to $120,000 worth of stock.

Beware though, there is a caveat. In the first example with the standard margin account, the trader may hold the position overnight. In the second example, the positions must be reduced to standard margin levels if the positions are not closed the same day. This means the holdings valued at $120,000 must be reduced to $60,000 (or less if there are trading losses) in order for the trader to continue to hold the positions into the next day. This is because Day Trading Buying Power can only be used when Day Trading. Even if the trader intended the positions to be day trades, but the trader does not exit before the market closes, these are no longer day trades. Either the trader will need to meet the overnight margin requirement of 50% of stock value, or the brokerage firm may take action to liquidate holdings in the account in order to bring it inline with federal and/or local margin rules. The term Day Trading Buying Power sounds simple enough, but many traders have been known to somehow "forget" the capital is for Day Trading only.

Leverage is a Double-Edged Sword

Leverage and margin are trading tools that should be used wisely. Financially speaking, leverage is when a small amount of capital is able to control a much more expensive asset or group of assets.

When trading and investing, leverage has the ability to magnify the skill set of the trader. If the trader is adept and able to profit while trading, leverage (margin) may help the trader to make profits faster and/or in larger quantities. However the reverse is also true. If the trader is not proficient and racks up trading losses, he or she will do so more quickly and in larger amounts when using margin.

When you day trade with borrowed funds it is possible to lose more than your initial investment. A decline in the value of stock purchased may cause the brokerage firm to require additional capital to maintain the position. Absence of an immediate additional capital infusion may cause the broker to liquidate client positions at its discretion. Likewise, the same can happen with a short stock position. This can result in an unlimited losses. So although access to increased margin with a Pattern Day Trade account can be beneficial, there is no guarantee that the account will be profitable. In addition, a trader will be able to make more transactions due to the increased access to trading capital. Since expenses can pile up quickly, it is crucial for Day Traders to monitor and control these.

 

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