The stock market is governed by various rules designed to ensure fairness, legality, and the prevention of various nefarious schemes. Some of these regulations drill down to handle the very way certain trading practices are executed. One of these rules is a regulatory decree governing what are known as pattern day traders. On the surface, the rule is to designed to keep a close watch on day traders and their practices of playing the market at breakneck speed. Yet there’s more to the rule than merely keeping a watchful eye on how a day trader operates.
A Pattern Day Trader Defined
A pattern day trader is not so much definitive of a term as it is an action. Essentially, if a day trader makes four or more day trades in a rolling five-day business frame, and same-day trades make up at least 6% of the investors activity during that time frame, the investor’s account will be immediately labeled as a Pattern Day Trade account. When this happens, certain limitations will then be applied relative to the investor’s account equity. That is, the amount of money that would exist if all of the positions in the investor’s account were closed. This term can also go by the name of liquidation value.
According to the rule, investors under its mandate are required to keep a minimum of $25,000 in their accounts. If their accounts fall below this minimum threshold, they will be denied access to the markets. What’s more, they will also receive impositions on the dollar amount that they can trade on a given day. If they surpass the limit, they will receive a margin call that will have to be met within three to five days. What’s more, any deposit that the investor makes to cover any required margin call will have to stay in the account for a minimum of two days.
The History of the Pattern Day Trading Rule
The genesis of the pattern day trading rule goes back to February 27, 2001, when the U.S. Securities and Exchange Commission (SEC) implemented the rule to handle the burgeoning presence of day trading and margin accounts. The rules, which were patterned on changes proposed by the New York Stock Exchange (NYSE) the Financial Industry Regulation Authority (FINRA), and the National Association of Securities Dealers (NASD), effectively boosted the margin requirements for day traders. This created the term “pattern day trader” in addition to producing an updated set of regulations for the day trading set. Technically, the “rule” isn’t a rule at all – it’s an amendment to the existing NYSE Rule 431, a rule that attempted – and failed – to create margin requirements for day traders.
The Benefits of the Pattern Day Trading Rule
At first glance, the pattern day trading rule may seem like some sort of punishment targeting day traders for practices that go outside the box when compared to traditional trader types. However, the pattern day trading rule actually serves to be quite beneficial to the day trader, provided he or she meets the minimum balance requirement of $25,000.
For instance, the day trader that falls under the pattern day trading rule can enjoy an increased access to margin. This ultimately produces an increase in leverage. For instance, a pattern day trade account will have access to around twice the standard margin amount when compared to day traders not subject to the rule. This unique wrinkle has a name – Day Trading Buying Power. When you consider that normal day traders can have hold positions of value up to double the amount of cash in their account, you’ll see that an investor with day trading buying power will have the capacity to carry up to four times the amount in hold positions relative to the amount of cash in their account.
Ultimately, the boost in leverage and margin that the pattern day trading rule can provide can provide a significant measure of “oomph” to the day trader’s skill set. If the investor is nimble and sharp enough to turn profits during trading, the increased leverage could help him or her to make even larger gains, and in faster times.
The Downside to the Pattern Day Trading Rule
The pattern day trading rule actually looks pretty enticing to the day trader that has the sufficient capital to hook into its required parameters. And while it does indeed carry a great potential for being a financial boon, it does have a dark side – particularly if you’re not as skilled of an investor as you think you are.
Simply put, a trader that is not proficient in taking advantage of the leverage afforded to him or her by the pattern day trading rule can be in for a world of hurt. Just like substantially larger gains can rack up with great efficiency, losses can come in large, expedient quantities.
These super-fast losses can happen when the day trading investor hits the market with borrowed funds procured by the day trading buying power and things go south. Indeed, it is quite possible for a person to lose more than the initial investment. This drop in stock value may require the investor’s brokerage firm to require extra capital in order to maintain the position. If this can’t be done, the brokerage may end up liquidating the client positions. This could conceivably spell disaster for investor.
The Bottom Line
The concept of the pattern day trading rule comes equipped with a bevy of advantages. However, just like it is with every type of trading strategy on the market, the utilization of the tools that come with the rule are not a foolproof protector against losses. There are risks that the investor will need to take into account.
However, the savvy investor can use the benefits of the pattern day trading rule to make a broader range of decisions that boil down to figuring out ways to maximize profits while minimizing risks. The rule may look like a punishment of sorts for the day trader at first glance, but upon further scrutiny, it’s clear that the rule is steeped in potential rewards.