What Is the Pattern Day Trading Rule?
If there’s any such thing as conventional wisdom regarding day trading, it’s this: Don’t try it unless you really know what you’re doing. Leave it to the professionals, who have the right combination of experience, expertise and nerve to navigate the extreme highs and lows that come with trying to time the stock market daily for maximum profits.
Day trading is a high-risk business that can produce huge returns or wipe out your savings — especially when it involves leveraged or margin trading strategies, which it often does. Even the Securities and Exchange Commission warns investors about the hazards of day trading, stating on its website that day trading is “not something you just dabble in for fun.” Most stock-market experts will tell you to avoid it.
But if you are determined to take a shot at day trading, you need to learn the rules. One of the most important is the “pattern day trading rule.” The Financial Industry Regulatory Authority defines a pattern day trader as any margin customer who makes day trades four or more times in five business days — provided that the number of day trades is more than 6% of the customer’s total trading activity for that same five-day period.
But that’s only part of what you need to know about the pattern day trading rule. Keep reading to learn more about it — and how to avoid making costly mistakes.
What Is Day Trading?
Before diving into the pattern day trading rule, it’s important to understand exactly what day trading is. The SEC defines it as “actively buying and selling securities within the same day, trying to capitalize on short-term changes in price.” These trades typically involve buying and then selling, or short selling and then buying, the same security on the same trading day. Many day traders borrow or leverage money to purchase additional assets.
To be successful at day trading — or at least to avoid taking huge losses — you need to understand the risks that accompany leveraged investment strategies like trading on margin or using options. “Leveraging” means increasing the money behind a given trade to maximize the potential returns, whereas margin trading means borrowing money — typically from your broker — and using it to speculate on securities. An option is essentially a contract that gives the buyer the right to buy or sell underlying securities at a predetermined price and within a specified time period.
It takes years to build up the kind of expertise needed to understand leveraged products, margin trades and options and then execute day trades successfully. But if you are just starting out, there are some terms you’ll want to be familiar with. Here are a few from the website of online broker TD Ameritrade:
- Open and close: Also known as a “round trip,” this simply means buying and selling a security or, for short sellers, selling short and then buying a security.
- Security position: This refers to the type of security being traded, such as stocks, bonds, exchange-traded funds and options.
- Same day: Although this might seem self-evident, it’s important to understand that a “same-day” trade is one in which you do a round trip on the same trading day. It’s not a same-day trade if you hold your position beyond the close of the trading day.
Day Trading Strategies
As with any type of investment, if you expect to succeed at day trading you’ll need to brush up on a few strategies. Here are some rules for rookie day traders that were listed by MarketWatch:
- Enter, exit and escape: Before making a trade, decide on an enter price, exit price and escape price, also known as a stop price. This rule sets boundaries on when you should get into a trade (enter) and get out (exit) to maximize profits. It also lets you know when to run for the hills (escape) in order to minimize potential losses.
- Don’t trade during the first 15 minutes after the market opens: The first 15 minutes are often when investors make panic trades or market orders placed the night before. Many professional day traders avoid making moves immediately after the market opens.
- Use limit orders instead of market orders: A limit order is one for a stock trade that will only be executed at the bid or ask price included in the order. A market order tells your broker to buy or sell at the best available price. Limit orders give you the power to control the maximum price you’ll pay or the minimum price you’ll sell, which lowers the risk on your end.
- Avoid trading on margin: As mentioned earlier, using margin means borrowing money from your broker to finance part or all of a trade. Because of the availability of extra financing, getting a margin can help you maximize your returns — if done right. But it can also greatly increase your potential losses.
- Develop a selling strategy: It might be more fun to focus on stocks you want to buy, but it’s more profitable to focus on setting price and time targets that let you know the best time to sell a stock.
What Is Pattern Day Trading?
Pattern day trading involves margin customers who make day trades at least four times in five business days, provided that the number of day trades is more than 6% of the customer’s total trading activity over the same five-day period.
Good To Know
Beyond that, pattern day traders must maintain equity of at least $25,000 on any days they make day trades. This minimum equity must be in the account prior to day-trading activities. If the account falls below the $25,000 requirement, the pattern day trader won’t be allowed to day trade until the account is restored to the $25,000 minimum equity level.
Pattern Day Trading Rules
According to FINRA, pattern day trading rules let customers trade up to four times the maintenance margin excess in the account, as of the previous day’s close of business. “Maintenance margin” refers to the minimum amount of equity an investor must maintain in a margin account after a purchase has been made.
If pattern day traders exceed the day-trading buying limitation, they’ll be issued a day-trading margin by the brokerage. When this happens, the customer will have a maximum of five business days to deposit funds to meet the day-trading margin call. Until the margin call is met, the day-trading account will be limited to day-trading buying power of two times the maintenance margin excess, based on the customer’s daily total trading commitment.
If the day-trading margin call is not met by the fifth business day, the account will be further restricted to trading only on a cash available basis for 90 days, or until the call is met.
Pattern day trading rules also require that funds used to meet the day-trading minimum equity requirement, or to meet day-trading margin calls, remain in the customer’s account for two business days following the close of business on any day when the deposit is required. In addition, the rules prohibit the use of “cross guarantees” to meet any of the day-trading margin requirements. A cross guarantee refers to an arrangement between two or more entities to provide a guarantee to each other’s obligations.
Types of Pattern Day Traders
TD Ameritrade lists two basic kinds of pattern day traders on its website:
- Self-identified: Customers who clearly operate as day traders, meaning their brokerage knows they intend to day trade, and that they meet the $25,000 minimum account value requirement
- Violators: Customers who day trade in violation of the rules, without meeting the capital requirement
What Happens If You Violate the Pattern Day Trading Rules?
Some brokerages might not do anything to customers who violate the pattern day trading rules, beyond flagging them internally as a way of keeping an eye out for repeat offenses. If you make an additional day trade while flagged, you could be restricted from opening any new positions.
Other brokerages might subject you to a minimum equity call, which means you’ll have to deposit enough money to meet a minimum account value of $25,000 — even if you don’t expect to day trade on a regular basis. Until this call is met, your trading privileges might be suspended for 90 days, and you could be limited to only closing out positions. Your margin buying power might also be suspended, which means you can only make cash transactions.
For customers with no intention of day trading, these kinds of restrictions can create unwanted headaches. One option is to contact your broker, who might be able to offer alternatives to avoid trading restrictions. Just keep in mind that it could take 24 hours or more for the day trading flag to be removed.
What To Consider Before Taking a Shot at Pattern Day Trading
Pattern day trading is a high-risk and often complex business that requires customers to have a deep knowledge of financial markets, leveraged products, options, margin calls and short selling. You’ll need to keep a pretty large amount of money in your account to participate, and you’ll need to ensure you don’t violate rules that could limit your ability to make trades even if you aren’t a day trader. If you are just starting out as a securities trader, you’re better off gaining experience before taking a shot at day trading.
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