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VIDEODefining a Pattern Day Trader
There are lots of reasons to day trade, but here are the lesser known requirements to know before starting.
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For some traders, the whole idea of day trading was a path to easy riches with no risk. It was the fad of the day and it worked -- until the market turned and fell, meaning a lot of portfolios based on accumulated day trades collapsed. And as most traders know, market prices tend to fall more rapidly than they rise.
Trading on such extreme leverage is an attractive idea, but it's not the only motive for day trading. Many traders believe that the risk of price gaps between today’s close and tomorrow’s open are simply too great; day trading enables traders to close out positions during the trading day, avoiding this risk altogether. Even so, if you want to day trade, you could fall into the definition of a “pattern day trader.”
Day trading relies on a high frequency of trades in very short timeframes measured not in days but in seconds. The entry/exit decision is based on momentum, chart patterns, and other technical strategies. Whichever strategy employed, the theme to day trading is that positions close before the trading day’s end. Margin requirements are calculated based on open positions at the end of the day; so day traders following the system end up with no open positions and no margin calls.
This problem, at times representing unacceptable risks to brokers as well as to traders, is what led to the enactment of new rules concerning so-called pattern day traders. By definition, you're a pattern day trader if you buy or sell a security within the same day, and follow this pattern four or more times within five consecutive trading days. If you do fall into this definition, you must maintain at least $25,000 in equity balances (cash and securities) in your margin account. This balance has to be on hand before you can continue any day trading, once you reach that threshold. This rule, called SEC Rule 2520, was put into effect on February 27, 2001.
One exception: If your day trading is lower than 6% of the total number of trades you make in the five-day period, then you're not considered a pattern day trader. So high-volume traders can escape the rule under this provision.
The pattern day trading requirement is one of those unexpected surprises so many traders discover in their margin accounts. The rules are easily understood in hindsight, but unfortunately they're likely to come to your attention only after you fall into the zone in which they kick in and apply to you.
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