How the Pattern Day Trading Rule Affects Investors
Violating the pattern day trading rule can be a costly mistake for active investors. For the uninitiated, it can result in trading restrictions or a locked account. And when that happens, any holdings can be blocked from being sold… meaning the potential loss of short-term profits.
How the pattern day trading rule is enforced varies between different brokerages. But the baseline for what triggers it as established by the Financial Industry Regulatory Authority (FINRA) is pretty clear. A pattern day trader is…
Any margin customer that day trades (buys then sells or sells short then buys the same security on the same day) four or more times in five business days, provided the number of day trades are more than 6% of the customer’s total trading activity for that same five-day period.
A Primer on Margin Accounts
Now let’s unpack the FINRA rule a little further. A margin customer is someone who borrows money from their brokerage and invests it. This might sound beyond the scope of the average investor, but it’s more common than you might realize.
For instance, a margin account is the default type of account when signing with some online brokerages like Robinhood. This makes it easier to immediately trade using funds as they are deposited. This is opposed to having to wait for them to be processed, which can take multiple days.
One way to get around the margin account aspect of the rule is to maintain a cash account. This will slow the transfer of funds (not ideal for day traders). This means that it can take multiple days to start using money deposited. It also means that it can take multiple days to collect funds from the sale of any securities. But depending on the rules set forth by the brokerage, this can be a way to get around triggering the pattern day trading rule.
The Pattern Day Trading Rule on Day Trading
Again, as defined by FINRA, day trades consist of the buying and selling of the same asset during the same day. Let’s say an investor wakes up and sees that Seagate Technology (Nasdaq: STX) is trading a little low. The company’s quarterly earnings call is later in the day, and they’re expected to beat expectations.
If the investor were to buy 100 shares in the morning and then sell those 100 shares in the afternoon after the earnings call (hopefully pocketing a profit in the process), that’s a day trade. Do this four days in a row and that can trigger the pattern day trading rule.
The 6% Rule
If you have a margin account and are actively trading assets in a single day, there’s still one more piece of the puzzle that needs to be covered. Those day trades have to represent more than 6% of the trader’s total activity over a five-day period. But hitting the 6% rule is easy.
In this example, let’s say our trader has $5,000 in their margin account. They’ve got their eye on some penny stocks this week. Over the course of the week, they’re in and out of several positions. But since they were all penny stocks, it amounted to only about $400 of actual activity. Well, that’s more than enough.
For a margin account with $5,000 in it, it takes only $300 (6% of $5,000) to trigger the pattern day trading rule. Those with $10,000 in their account can make up to $600 in trades without worrying about the rule. For those with $20,000, the number doubles again. But for those with at least $25,000 in their account, the rules change completely…
Day trading margin rules were designed to protect new investors from engaging in risky behavior. And day trading is inherently risky. Even those who know all of the day trading rules and keep up on day trading strategies can make costly mistakes. This is part of the reason the $25,000 rule was put into place.
Now, being flagged as a pattern day trader isn’t fundamentally bad. There are lots of people out there who make lots of money day trading. In fact, most of those with at least $25,000 in their margin account can make as many day trades as they want… but it does make sense to double-check with your broker first.
Also worth noting, the $25,000 total can be any mixture of cash and securities in the account. But that might not make much of a difference to the day trader who ends most days without any security holdings. Nonetheless, the active day trader has generated financial risk by entering and exiting positions. That’s why the 6% rule was put in place.
But there are some limitations even those with $25,000 in their account need to consider. Pattern day traders are allowed to trade up to four times the maintenance margin excess (the margin available for trading) in their account. If that day trading buying power limit is surpassed, the brokerage can issue a day trading margin call.
Day Trading Margin Calls
Margin trading comes with its fair share of power and pitfalls. It can add a potent boost to an investor’s purchasing power. It can also lead to devastating results. And that’s equally true for day traders.
When a day trader exceeds purchasing power limitations, the brokerage will usually issue a day trading margin call. This is to cover the deficiency in margin and return funds to the account minimum. This amounts to the day trader needing to deposit funds in their account to meet the margin call within five days. Until this happens, the day trader’s account can be restricted in various ways.
The Bottom Line on the Pattern Day Trading Rule
New investors generally aren’t too keen on financial institutions telling them how and when they can invest. But this is exactly the type of investor the pattern day trading rule was put in place to protect. There are lots of rules when it comes to day trading because there’s a lot of risk.
Day trading successfully takes a lot of practice and an intimate understanding of the pattern day trading rules. For new investors, it’s best to start by using a stock trading simulator. This allows potential day traders to test their strategies without the risk of losing their shirt.
For those looking for more specific trading advice, we suggest signing up for the Trade of the Day e-letter. It’s simply the best way we know of for new investors to learn about smart speculation in fast-moving markets.