The Pattern Day Trader Rules

Well, this is a really old article I wrote back when the Pattern Day Trader Rules were first introduced. I'm reposting it now, however, because I still get a lot of questions from newer traders on what exactly this rule is and how does it affect them. Namely, putting it to them in straight terms instead of with some legal mumbo jumbo... So, here it is:

The Pattern Day Trader Rules

Beginning September 28, 2001 margin rules and requirements for one group of traders changed dramatically. The new rules apply to traders categorized as Pattern Day Traders (PDTs) . These are traders who make 4 or more day trades within a 5 day period, unless his/her day-trading activities do not exceed 6% of his/her total trading activity for that time period. Thus, if you have only 4 daytrades in a 5 day period but have done more than 67 trades during that time, then less than 6% of the trades were day trades and hence do not categorize you as a PDT.

A day trade refers to opening and closing a position within the same trading day. If you are in a position with one entry of 1000 shares and you take two exits of 500 shares each within the same day then this is only considered one day trade. You could also be categorized as a PDT right away without waiting to see your 5 day record if your trading firm has reason to believe you will be a PDT. For instance, if the broker trained you solely to day trade, then they will label you as such from the beginning.

There are several main changes which now affect pattern day traders that did not apply before 2001. One is that PDT's must have a minimum of $25,000 to open a margin account as opposed to previous requirements of a mere $2000. Funds deposited into a day trader's account to meet the minimum equity requirement have to remain there for at least two business days following the close of business on the day the deposit was made.

Many brokers now require all PDTs to have the minimum $25,000 even if they are trading from a cash-only account as the new rule is unclear about trading from cash accounts. It does clearly prohibit it and yet, neither does it state that it is allowed. Day trades in a cash account cannot violate the free-riding prohibition of the Federal Reserve Board’s Regulation T. Generally speaking, free-riding is failing to pay for a security before you sell that security in a cash account. It can take 3 business days for your purchase of a security to settle. If determined that you free-ride, then your broker must place a 90-day freeze on your account. Typically, the free-riding label is determined based upon repeat behavior. If you are a longer term trader, for instance, but are forced to exit a position due to a stop hitting, you will not generally be considered to be in violation of this regulation.

Another major change is that PDTs now have twice the buying power as they did before. While traders once had access to 2:1 margin, they now have 4:1. Whether you choose to use this increased buying power or not is completely up to you, although you should still base your risk per trade upon your account size, not the amount you have available to you as a result of margin.

There are several notable changes on how margin calls are handled as well. One which used to be a thorn in the side for many traders has now been eliminated. In the past, a position sold and repurchased on the same day which was opened on a previous day was considered a day trade and often led to margin calls by traders due to differences in intraday and overnight margin. This possibility no longer exits since the sale of the position is now treated as a liquidation of the existing position and the subsequent repurchase is considered to be the establishment of a new position which is not subject to the rules affecting day trades unless it is also closed that same day.

Additionally, cross-guarantees to meet daytrading margin calls, as well as minimum equity requirements, are now prohibited. This means a trader cannot borrow from another trader to meet a margin call or minimum equity requirement. The trader is independently responsible for meeting margin calls or minimum equity requirements.

Should a trader receive a margin call, his/her buying power will be cut in half. Instead of 4:1 they will only have 2:1 margin until the call is met. If the call is not met by the fifth business day then the PDT would be limited to trading on a cash basis for 90 days or until the call is met.

Swing traders and position traders are not affected by the PDT rule, but you must be careful. Traders mixing styles or taking stops in the same day the position sets up are at risk of being considered a pattern day trader as only six trades out of every 100 you make within a 5 day period can be day trades before you are labeled a PDT. For those unfamiliar with these terms, a swing trader is typically one who holds a position overnight for about 3-5 days based upon daily pattern setups. A position trader is one who is trading based upon weekly or monthly setups and tends to hold for several weeks to several months.

For more in depth information on these rules please refer to the NASD Regulation Website at http://www.nasd.com/.