Pattern Day Trading Rule: Understanding Pattern Day Trading Rule and Using it in the Exchange Market

Do you intend to become a day trader? I am not sure what your answer is, but it is important to know the ins and outs. Pattern day traders are people who buy and sell stocks on a short-term basis with the intent of making quick profits by exploiting price discrepancies in different securities. Day trading be an exciting way to get into investing because you can make money fast! However, there are few pitfalls that you should know about before jumping in headfirst. For example, pattern day trading requires more than just knowledge of technical analysis; many successful traders have other skills like psychology in order to read market sentiment correctly. There are also strict rules for pattern day trading that must be followed or else risk being kicked out of your trading market.

What is Pattern Day Trading Rule?

The pattern day trading rule is an SEC regulation that requires you to maintain minimum account equity of $25,000 in order to day trade. If your account goes below this threshold for any reason, like if the market suddenly crashes and you lose all your money or if you take out a margin loan (more on that later), then you are not allowed to day trade until your account is back up to $25,000.

Therefore, we can define Day Trade as buying and selling the same security on the same day, regardless of the trades' time. New accounts that engage in four or more day trades during a margin period of fewer than six months will be treated as pattern day traders for the remainder of that margin period.

Who is a Pattern Day Trader?

"As a pattern day trader, you are any customer who executes four or more "day trades" within five business days. In determining whether a day trade is undertaken to produce profits, the satisfaction of all requirements for that person's account with respect to day trading shall be considered." So you must satisfy *all* of the day trading requirements for your account to be considered a day trade.

I'm a Pattern Day Trader. What does this mean?

You are to liquidate your positions at any time - including overnight. Some brokers may be more lenient than others with overnight positions, though, so give them a call to ask what their policy is with this regard.

What Happens If I Violate the Pattern Day Trading Rule?

If you violate the pattern day trading rule, your brokerage will close out all of your positions at market price, which usually means huge losses for both novice and experienced traders.

Is There an Alternative to Pattern Day Trading?

Yes, there is. The alternative to pattern day trading is called margin trading, and it basically works like this: instead of using your own money to buy stocks, you borrow money from the brokerage (this is called a margin loan). Now there are two types of margin loans; 

·         Reg T Margin (Regulation T)

·         Portfolio Margin.

Reg T Margin

With Reg T margin, you can buy on margin up to 50% of the total market value of stocks that you own (this is called the Reg T maintenance requirement). This means that if your trading account contains $20,000 worth of stock, then you can borrow an additional $10,000 using a margin loan. When you're day trading, this leverage is good because it allows you to trade more stock with the same amount of cash. It can be bad because if your stock value decreases by 1%, then instead of losing 100% on your investment ($2,000), you actually lose 106% ($2,060). Portfolio margin works similarly, but with a lower borrowing limit in most cases (it can be as low as 50% in some portfolios) and no incentive to encourage short-term trading.

Portfolio Margin

Portfolio margin is different than Reg T margin in many ways, including that you can hold securities on margin for two days rather than the usual one day before paying for them, and it's the minimum margin requirement for short sales. You can open a portfolio margin account with $5,000 of securities at Interactive Brokers, and by the way, they charge .015 per contract on options trades (minimum is $7), you'll be able to trade more than 1,500 contracts if you're following our stock picks.

Portfolio Margin is also different in that while you must pay the interest on the balance all the time, if your account is worth more than $1,000,000, then you can get free financing on any new margin debt. This means that even though margin interest rates are high compared to Treasury bills, they are locked in indefinitely rather than being subject to change on a daily basis.

Pattern Day Trading Rule at a Glance

To be termed a Pattern Day Trader, you must meet all three of the following criteria in any 5-consecutive-trading-day period:

a.       You must execute four or more day trades.

b.      The number of day trades executed must be more than 6% of your total trading activity for that same five-business-day period.

c.       The amount net gain/loss must be more than $1000 per 4-day trades

Advantages of being a Pattern Day Trader

a.       The primary advantage of pattern day trading is that investors are able to apply their skills and expertise for their own benefit. This means that traders can take control of their own investments without having to rely on the decisions made by other people. However, this does not mean that an investor cannot turn to brokers or financial advisors for advice.

b.      You can buy and sell the same security on the same day up to four times. 

c.       You can trade in any amount you wish, as long as it is not greater than your margin balance or $25,000, whichever is less. 

d.      For purposes of the pattern day trader rule, a pattern day trader only includes those accounts that execute four or more day trades in five business days. 

Drawbacks of Being a Pattern Day Trade

There are red flags that go up if someone qualifies as a Pattern Day Trader. First, if you hold your position open overnight, it will be treated as a margin trade and not an investment account trade. This means that the broker is allowed to liquidate positions in your account according to their cash available for margin purposes and then apply the proceeds towards your margin debt. Unfortunately, this is at the broker's discretion, and you might get called on an "accelerated close out" where your positions are closed prior to market close just so that you don't get the kick in the pants of a substantial loss.

It should be noted that even if you aren't deemed a Pattern Day Trader by your broker, they are perfectly entitled to liquidate your positions at any time - including overnight. Some brokers may be more lenient than others with overnight positions, though, so give them a call to ask what their policy is in this regard.

Why Could I be Flagged as a Day Trader?

You can be flagged by your broker from time to time as a day trader. First, this can happen when you use your account to transact more than the required times (4 times). Even when you don't trade, your broker may assume that you are a pattern day trader and assume that you are continuously trading. However, you can stop this by changing your trading strategy by contacting your brokerage firm.

Bottom Line

The Pattern day trading exercise may be tricky if you are new in the trading market. However, this field can be highly lucrative if you decide to trade and be able to apply proper risk management measures. This can also quickly build you a sample size that you can use as a learning resource.