Pattern Day Trading – Know the Rules

pattern day trader rule

A pattern day trader is any trader that buys and then sells the same security, or vice versa, on the same day four times or more within five consecutive working days. This is providing that the amount of day trades made equates to more than six percent of the trader’s total trading activity during that same five working day period. In order to make sure you are not breaching the rule as to the number of day trades you can make, you must first understand exactly what a day trade is.

A brokerage firm may be considered an individual a day trader if they believe that their pattern of trading is similar to that of a day trader. Similarly, if a brokerage firm gave the trader training on how to day trade prior to them opening their account, then it may consider them a day trader.

In those instances where a trader displays the pattern of a day trader one week but not the following week, then a brokerage firm will deem that individual a day trader. This is because they possess a reasonable belief that the individual is a day trader based on their previous activities. If you have made a change to your trading strategy, however, and are no longer a day trader, you should contact your brokerage firm to let them know.

What is considered a day trade?

A day trade is an action of selling than buying, or vice versa, the same stock within the same single day. Selling a stock without then buying it later in the day is not a day trade. The same is also true for short sales and trading in options. So, for example, if an investor were to sell short and then buy back to cover later that same day, then that would be a day trade.

Minimum equity requirement

The rules also state that a day trader must have a minimum of $25,000 of equity each day that they trade. This must be in the trader’s account before any day trading activities can take place. If the amount of equity in the account ever falls below the $25,000 level then the trader will no longer be allowed to trade until the minimum level of equity is restored.

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Under the rules, a day trader can only trade a maximum of four times that of the excess of the maintenance margin that was in the trader's account at the close of the previous working day. If a day trader exceeds this limit then the brokerage firm will issue a margin call for day trading to the trader. When this happens the trader has approximately five working days in order to make a deposit of funds to meet the margin call. Until this is done the account is restricted to a buying power of just two times that of the excess of the maintenance margin. If this is not done after five days then the trading account is further restricted so that only cash can be used until the margin call is met.

Further to this, the rules state that any funds, which are used to meet the minimum equity requirement or a margin call, must stay in the account of a day trader for at least two working days. Similarly, cross guarantees cannot be used to meet the minimum equity requirement or a margin call.

Does the minimum equity requirement have to be cash?

The minimum equity requirement of $25,000 can be met with entire cash or eligible securities or as a combination of both.

Can the minimum equity requirement be kept in a personal bank account?

The $25,000 minimum equity requirement has to be always kept in either a cash account or margin account with a brokerage firm. This is because the brokerage account is where the risk is taking place. The $25,000 is needed as support against the risks that are associated with day trading. The Securities Investor Protection Corporation (SIPC) protects up to as much as $500,000 of each trader’s assets. When making a claim with the SIPC there is a minimum of $250,000 cash.

Why did the minimum equity requirement come into effect?

A minimum equity requirement was first introduced all the way back in 1974 and was just $2,000. However, at first it was not applied to the activities of day traders and instead was aimed at those traders that bought and held.

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The main reason for a minimum equity requirement is so that traders are able to support the levels of risk associated with their activities of day trading. It was deemed that the rules relating to margin calls were not sufficient inadequately covering the risks present in certain day trading strategies. It also encouraged traders to use cross guarantees and did not discourage those with little financial know-how to cease trading.

Margin calls are worked out based upon a trader’s positions on securities at the close of the market each day. A trader that only makes day trades obviously does not have a position at the end of the day on which a margin call can be calculated. However, that trader has generated a certain amount of risk during the course of a day. The pattern day trader rule addresses this by forcing the need for a margin call to be calculated based on the trader’s biggest open position during the course of the day.

Were traders consulted on the changes to the rules?

The changes to the rules were granted approval from the board of directors at the United States National Association of Securities Dealers. They were then sent to the Securities and Exchange Commission to be filed. After this, the rules were published for comment and in excess of 250 comments were received by the commission. The National Association of Securities Dealers and the New York Stock for global seafood  Exchange responded to all of these and the amended rules on pattern day traders became active on 28 September 2001. You may Click Here to know more information.

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