If a day trader makes four or more day trades in a rolling five business day period, the account will be labeled immediately as a Pattern Day Trade account. Certain limitations will then be applied based on the account equity. (Account equity is the amount of cash that would exist if every position in the account were closed. This is also known as the liquidation value.)
A pattern day trader is one who trades the same security four or more times per day (buys and sells) over a five-day period, and for whom same-day trades make up at least 6% of their activity for that period. According to the rule, traders are required to keep a minimum of $25,000 in their accounts and will be denied access to the markets should the balance fall below that level. There are also restrictions on the dollar amount that they can trade each day. If they go over the limit, they will get a margin call that must be met within three to five days. Further, any deposits that they make to cover a margin call have to stay in the account for at least two days.
The pattern day trader rules were adopted in 2001 to address day trading and margin accounts. The U.S. Securities and Exchange Commission (SEC) rules took effect February 27, 2001 and were based on changes proposed by the New York Stock Exchange (NYSE), the National Association of Securities Dealers (NASD), and the Financial Industry Regulation Authority (FINRA). The changes increased the margin requirements for day traders and defined a new term, “pattern day trader.” The rules were an amendment to existing NYSE Rule 431, which had failed to establish margin requirements for day traders.
Benefits for pattern day traders
If the pattern day trader can maintain the minimum balance requirement of $25,000, there are certain benefits for this type of account. Increased access to margin - and therefore increased leverage - can be one of them.
For non-pattern day trade accounts with standard access to margin, traders may hold positions in value up to twice the amount of cash in their account. For example if the account has $30,000 in cash, the trader can buy up to $60,000 worth of stock. The trader uses the $30,000 and the brokerage firm lends the trader the remaining $30,000 on margin and charges interest on the loan.
Pattern day trade accounts will have access to approximately twice the standard margin amount when trading stocks. This is known as Day Trading Buying Power and the amount is determined at the beginning of each trading day. When trading stock, Day Trading Buying Power is four times the cash value instead of the normal margin amount cited above. So in the previous example, the trader would be able to trade up to $120,000 worth of stock.
Leverage and margin are trading tools and are meant to be used wisely. Financially speaking, leverage is when a small amount of capital is able to control a much more expensive asset or group of assets.
When trading and investing, leverage has the ability to magnify the skill set of the trader. If the trader is adept and able to profit while trading, leverage (margin) may help the trader to make profits faster and/or in larger quantities.
Caution for pattern day traders
If traders are not proficient, losses will rack up more quickly and in larger amounts when using margin.
When a trader day trades with borrowed funds (margin/day trading buying power) it is possible to lose more than the initial investment. A decline in the value of stock purchased may cause the brokerage firm to require additional capital to maintain the position. Absence of an immediate additional capital infusion may cause the broker to liquidate client positions at its discretion.
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