Stock and options trading in the U.S. is regulated by the Securities and Exchange Commission (SEC) and by the Financial Industry Regulatory Authority (FINRA). Back in 2001 they passed what’s come to be known as the pattern day trader rule, which has greatly impacted individuals’ ability to day trade stocks and options.
The SEC defines a pattern day trader as anyone who executes more than three day trades in a margin account over a five day period. This does not apply however if the number of day trades is not more than six percent of the total number of trades over that five day period. Day Trading Rules dictate that any trader who meets the pattern day trader definition is required to maintain at least $25,000 in his margin account. This amount it should be noted has not been modified since the rule was initially issued. If a trader triggers the pattern day trader rule he then has five days to meet the $25,000 margin requirement. If he cannot do that then he will not be allowed to day trade for 90 days or until he has the required funds in his account.
The purpose of the pattern day trader rule is to protect individual traders from overexposing themselves to the dangers of day trading by severely restricting the number of day trades they can take in a small margin account. It’s important however to look at the different elements of the definition and the rule to see whether it actually applies to a specific trader.
- Day trades are trades executed and closed within a single trading session. A trade that is opened today and closed tomorrow is therefore not included in this definition and any swing trader, even one who trades short duration swing trades, should not be impacted. It is of course possible that a swing trader with a large number of open positions may be forced to close several in the same day as the result of an unexpected news event and thereby trigger the rule.
- The rule only applies to margin accounts. Stock margin accounts typically allow 100% margin so a trader can buy $20,000 in stock if he has $10,000 in his account. If the account in question is a cash account, one that doesn’t carry any margin, then the trader is not restricted in the number of trades he can execute. As long as he has sufficient funds in his account to buy the stock, then he can day trade as often as he likes.
- If the number of day trades is not more than six percent of the total trading activity then the rule does not apply. That would mean that if the trader had executed a total of fifty trades over the five day period and three of those trades were day trades, then the rule would not apply because the total number of day trades was not more than six percent of the total number of trades. In practice it’s likely that anyone who meets this requirement already has more than $25,000 in his margin account.
- The rule applies to stocks and options. Futures and forex trading are not regulated by the SEC and therefore are not subject to the pattern day trader rule.
Whether or not the pattern day trader rule has helped reduce risk for individual traders is hard to judge or at least quantify. While it has probably kept traders with very small accounts out of the stock market, many of them will likely have moved over to spot forex trading which is much less regulated than either stocks or futures and other derivatives. Even those seeking to trade in well regulated markets have an alternative to stocks in the form of futures trading which provides even greater amounts of leverage than stocks.
As a stock trader of course you still have alternatives. The first is to increase your account funding to meet the $25,000 minimum. You can also switch to swing trading, either swing trading the stocks directly or swing trading options for much greater leverage and much more limited down side risk. Regardless of the direction you choose, be aware of the rules and regulations governing your account so that you are not caught unawares and penalized.
Good luck in your trading.