A pattern day trader is actually a designation created by the Financial Industry Regulatory Authority (FINRA), and it refers to traders who day trade a security four or more times within a five-day period.
Because of their status, there are certain rules and stipulations that apply only to pattern day traders, which brokerages and investing firms must adhere to.
Read on to learn more about pattern day traders, what rules apply to them, and how they’re different from regular day traders.
Pattern Day Trader, Definition
The FINRA definition of a pattern day trader is clear: A brokerage or investing platform must classify investors as pattern day traders if they day trade a security four or more times in five business days, and the number of day trades accounts for more than 6% of their total trading activity for that same five-day period in a margin account.
When investors are identified as pattern day traders, they must have at least $25,000 in their trading account. Otherwise, the account could get restricted per FINRA’s day-trading margin requirement rules.
How Does Pattern Day Trading Work?
Pattern day trading works as the rules stipulate: An investor or trader trades a single security at least four times within a five business day window, and those moves amount to more than 6% of their overall trading activity.
Effectively, this may not look like much more than engaging in typical day trading strategies for the investor. The important elements at play are that the investor is engaging in a flurry of activity, often trading a single security, and using a margin account to do so.
Remember: A margin account allows the trader to borrow money to buy investments, so the brokerage that’s lending the trader money has an interest in making sure they can repay what they owe.
Example of Pattern Day Trading
Here is how pattern day trading might look in practice:
On Monday, you purchase 10 shares of Stock A using a margin account. Later that day, you sell the 10 shares of Stock A and make a small profit, as Stock A’s price increased over the course of the day.
On Tuesday, you buy 100 shares of Stock A, and sell 50 shares after two hours at a loss, so you sell 50 more after another two hours. You’ve made another small profit, but have also completed three day trades within a couple of days, all involving the same security.
On Thursday, you once again buy 100 shares of Stock A, and make two sales a couple of hours apart, just as you did on Tuesday, and come out even. You’ve now executed more than five trades with a single security within five business days, and run the risk of being labeled a pattern day trader.
Do Pattern Day Traders Make Money?
Yes, pattern day traders can and do make money — if they didn’t, nobody would engage in it, after all. But pattern day trading incurs much of the same risks of day trading. Day traders run the risk of getting in over their heads when using margin accounts, and finding themselves in debt.
This is why it’s important for aspiring day traders to make sure they have a clear and deep understanding of both margin and the use of leverage before they give serious thought to trading at a high level.
It’s the risks associated with it, too, that led to the development and implementation of the Pattern Day Trader Rule, which can have implications for investors.
What is the Pattern Day Trader Rule?
The Pattern Day Trader Rule established by FINRA requires that an investor have at least $25,000 cash and other eligible securities in their margin account in order to conduct four or more day trades within five days. If the account dips below $25,000, the investor will need to bring the balance back up in order to day trade again.
Essentially, this is to help make sure that the trader actually has the funds to cover their trading activity if they were to experience losses.
Note that, according to FINRA, a day trade occurs when a security is bought and then sold within a single day. However, simply purchasing shares of a security would not be considered a day trade, as long as that security is not sold later on that same day, per FINRA rules. This also applies to shorting a stock and options trading.
The PDT Rule established by FINRA requires that an investor have at least $25,000 in their margin account in order to conduct four or more day trades within five days.
But merely day trading isn’t enough to trigger the PDT Rule.
All brokerage and investing platforms are required by FINRA, a nongovernmental regulatory organization, to follow this rule. Most firms provide warnings to their clients if they are close to breaking the PDT rule or have already violated it. Breaking the rule may result in a trading platform placing a 90-day trading freeze on the client’s account. Brokers can allow for the $25,000 to be made up with cash, as well as eligible securities.
Some brokerages may have a broader definition for who is considered a “pattern day trader.” This means they could be stricter about which investors are classified as such, and they could place trading restrictions on those investors.
A broker can designate an investor a pattern day trader as long as the firm has a “reasonable basis” to do so, according to FINRA guidelines.
Why Did FINRA Create the Pattern Day Trader Rule?
FINRA and the Securities and Exchange Commission (SEC) created the PDT margin rule during the height of the dot-com bubble in the late 1990s and early 2000s in order to curb excessive risk-taking among individual traders.
FINRA and the Securities and Exchange Commission (SEC) created the PDT margin rule amidst the heyday of the dot-com bubble in order to curb excessive risk taking among individual traders.
FINRA set the minimum account requirement for pattern day traders at $25,000 after gathering input from a number of brokerage firms. The majority of these firms felt that a $25,000 “cushion” would alleviate the extra risks from day trading. Many firms felt that the $2,000 for regular margin accounts was insufficient as this minimum was set in 1974, before technology allowed for the electronic day trading that is popular today.
Investing platforms offering brokerage accounts are actually free to impose a higher minimum account requirement. Some investing platforms impose the $25,000 minimum balance requirement even on accounts that aren’t margin accounts.
Pattern Day Trader vs Day Trader
As discussed, there is a difference between a pattern day trader and a plain old day trader. The difference has to do with the details of their trading: Pattern day traders are more active and assume more risk than typical day traders, which is what catches the attention of their brokerages.
Essentially, a pattern day trader is someone who makes a habit of day trading. Any investor can engage in day trading — but it’s the repeated engagement of day trading that presents an identifiable pattern. That’s what present more of a risk to a brokerage, especially if the trader is trading on margin, and which may earn the trader the PDT label, and subject them to stricter rules.
Does the Pattern Day Trader Rule Apply to Margin Accounts?
As a refresher: Margin trading is when investors are allowed to make trades with some of their own money and some money that is borrowed from their broker. It’s a way for investors to boost their purchasing power. However, the big risk is that investors end up losing more money than their initial investment.
Investors trading on margin are required to keep a certain cash minimum. That balance is used as collateral by the brokerage firm for the loan that was provided. The initial minimum for a regular margin account is $2,000 (or 50% of the initial margin purchase, whichever is greater). Again, that minimum moves up to $25,000 if the investor is classified as a “pattern day trader.”
FINRA rules allow pattern day traders to get a boost in their buying power to four times the maintenance margin excess – any extra money besides the minimum required in a margin account. However, most brokerages don’t provide 4:1 leverage for positions held overnight, meaning investors may have to close positions before the trading day ends or face borrowing costs.
If an investor exceeds their buying power limitation, they can receive a margin call from their broker. The investor would have five days to meet this margin call, during which their buying power will be restricted to two times their maintenance margin. If the investor doesn’t meet the margin call in five days, their trading account can be restricted for 90 days.
Does the Pattern Day Trader Rule Apply to Cash Accounts?
Whether the Pattern Day Trader Rule applies to other types of investing accounts, like cash accounts, is up to the specific brokerage or investing firm. The primary difference between a cash account vs. a margin account is that with cash accounts, all trades are done with money investors have on hand. Some trading platforms only apply the PDT rule to margin accounts and don’t apply it to cash accounts.
However, some platforms may adhere to FINRA rules that govern margin accounts even if they don’t offer margin trading. This means that a $25,000 minimum balance of cash and other securities must be kept in order for an investor to do more than four day trades in a five-business-day window.
Investors with cash accounts also need to be careful of free riding violations. This is when an investor buys securities and then pays for the purchase by using proceeds from a sale of the same securities. Such a practice would be in violation of the Federal Reserve Board’s Regulation T and result in a 90-day trading freeze.
Pros of Being a Pattern Day Trader
The pros to being a pattern day trader are somewhat obvious: High-risk trading goes along with the potential for bigger rewards and higher profits. Traders also have a short-term time horizon, and aren’t necessarily locking up their resources in longer-term investments, either, which can be a positive for some investors.
Also, the use of leverage and margin allows them to potentially earn bigger returns while using a smaller amount of capital.
Cons of Being a Pattern Day Trader
The biggest and most obvious downside to being a pattern day trader is that you’re contending with a significant amount of risk. Using leverage and margin to trade compounds that risk, too, so day trading does require thick skin and the ability to handle a lot of risk. (Make sure to consider your risk tolerance and investment objectives before engaging in day trading.)
Given the intricacies of day trading, it can also be more time and research intensive.
Tips to Avoid Becoming a Pattern Day Trader
Here are some steps investors can take to avoid getting a PDT designation:
1. Investors can call their brokerage or trading platform or carefully read the official rules on what kind of trading leads to a “Pattern Day Trader” designation, what restrictions can potentially be placed, and what types of accounts are affected.
2. Investors can keep a close count of how many day trades they do in a rolling five-day period. It’s important to note that buying and selling during premarket and after-market trading hours can cause a trade to be considered a day trade. In addition, a large order that a broker could only execute by breaking up into many smaller orders may constitute multiple day trades.
3. Investors can consider holding onto securities overnight. This will help them avoid making a trade count as a day trade, although with margin accounts, they may not have the 4:1 leverage afforded to them overnight.
4. If an investor wants to make their fourth day trade in a five-day window, they can make sure they have $25,000 in cash and other securities in their brokerage account the night before to prevent the account from being frozen.
5. Investors can open a brokerage account with another firm if they’ve already hit three day trades over five days with one trading platform. However, it’s good to keep in mind that the PDT rule is meant to protect investors from excessive risk taking. It’s also important to know that taking time to make wise or careful investment decisions could be in the investor’s favor.
Pattern day traders, as spelled out by FINRA guidelines, are traders who trade a security four or more times within five business days, and their day trades amount to more than 6% of their total trading activity using a margin account.
Being labeled a pattern day trader by a brokerage can trigger the PDT Rule, which means that the trader needs to keep at least $25,000 in their margin account.
While day trading can reap big rewards, it also has big risks — and that’s something that brokerages are keenly aware of, and why they may choose to have stricter requirements for pattern day traders.
You can invest in stocks without becoming a day trader, of course. It’s easy when you open an account with SoFi Invest and set up an Active Invest account. You won’t pay any SoFi trading commissions, and you can learn to buy, sell, and trade stocks as you go.
What happens if you get flagged as a pattern day trader?
If you’re labeled as a pattern day trader, your brokerage may require you to keep at least $25,000 in cash or other assets in your margin account as a sort of collateral.
Do pattern day traders make money?
Yes, some pattern day traders make money, which is why some people choose to do it professionally. But many, perhaps most, lose money, as there is a significant amount of risk that goes along with day trading.
What is the pattern day trader rule?
The Pattern Day Trader Rule was established by FINRA, and requires traders to have at least $25,000 in their margin account in order to conduct four or more day trades within five days. If the account dips below $25,000 the trader needs to deposit additional funds.
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