What Is The Pattern Day Trader Rule?

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By Adrian Cruce

“Pattern Day Trader” is an official regulatory designation. It is used to describe investors or traders that execute over 4 day trades in a period of 5 business days. The pattern day trader rule is practically the set of rules that exist for the pattern day traders.

Basically, the pattern day trader is someone that sells or buys a security on one day in a specific margin account. The traders need to have over 6% of the trades happen at the same margin account in the analyzed period in order to be considered as being separate from the standard day trader. Such securities can include short sales and stock options. However, these need to happen on the exact same day. The exception to this rule is having short and long positions that were held overnight but sold before new purchases were done of the exact same security in the following day.

FINRA (Financial Industry Regulatory Authority) determines the pattern day trader designation. It is different than the standard day trader through how much day trade is completed during a specific time frame. Both of these groups have some mandatory minimum assets that have to be put in margin accounts. However, the pattern day trader needs to hold over $25,000. When equity account drops under this amount, it is not allowed to make other day trades. Balance has to be brought back to at least the minimum.

When a margin call exists, pattern day traders have 5 business days for the answer. Until a call is met, trading is restricted to 2 times maintenance margin. When the issue is not addressed in 5 business days, an automatic 90 days cash restriction status happens for the account. Alternatively, the restriction is removed when issues were resolved.

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Rules are now industry standard. However, individual brokerage firms can have much stricter interpretations. Investors can sometimes self-identify as being day traders.

Pattern Day Trading Example

Let’s take a fictitious trader named John. He is a day trader and has assets of $30,000 inside a margin account. In this case the average margin account is $60,000 and John is allowed to buy stocks worth a maximum of $120,000. When the stocks gain 1% during the duration of the day, because John is a pattern day trader, he can generate a 4% gain. With standard margins the gain is 2%.

Pattern Day Trading Disadvantages

Many traders do all that they can in order to avoid being labeled as pattern day traders. There is a potential for a huge return but there is also the possibility that a lot of money is going to be lost. The risk associated with pattern day trading is high. With this in mind, some of the downsides associated with pattern day trading include the following:

  • The Minimum Balance

If you are officially classified as being a pattern day trader, you are forced to maintain the minimum $25,000 balance. This is necessary at all times. If you get under the minimum by even $1 you are no longer allowed to participate.

  • High Risk

The risks are higher with pattern day trading. This is why the SEC is keeping a close watch on it. However, if you are experienced, such risks can be reduced. In fact, many pattern day traders love taking advantage of the higher margin that is available. The big problem is that there is a forced rule of minimum balance in place. Some traders will try to avoid that by keeping a position for a longer period of time, usually until the following day. Unfortunately, this opens the doors to even higher risks.

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Avoiding The Pattern Day Rule

Different regulatory bodies might label you as a pattern day trader and you might want to avoid that. The very best way to do this is to trade securities where rules do not apply. For instance, the Forex and futures markets are short-term based. Traders need to regularly trade. However, if you want to choose out of the two, the futures market is the one that is normally considered since there is extra price transparency in place when compared to Forex.