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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
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Michael C. Thomsett, author
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Getting Started in Stock Investing and Trading
  • Are You A Pattern Day Trader? 0 comments
    Dec 7, 2013 9:38 AM

    Anyone trading options knows how little effort it takes to build up a healthy volume of transactions. But you should be aware of one rule that could inhibit your ability to trade too often in the same option and in the same stock.

    In the past, day trading represented the wild west of the market. It was possible for day traders to move in and out of positions within the trading day and end up with no open positions. This meant it was possible to trade on large volume with little or no cash at risk, meaning no margin requirements. It also meant huge risks for brokers.

    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 is 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 are a pattern day trader if you buy or sell a security four or more times within five consecutive trading days. If you 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 are not considered a pattern day trader. So high-volume traders can escape the rule under this provision.
    The pattern day trading requirements is one of those unexpected surprises so many traders discover in their margin accounts. The rules are easily understood in hindsight, but unfortunately they are likely to come to your attention only after you fall into the zone in which they kick in and apply to you.

    Rules like this certainly limit how much you can do on margin, especially when it comes to working within the rules. ThomsettOptions.com encourages members to engage in lively discussions on the members' forum and in live chat to share information about this and other rules of the game.

    To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. You can take part in discussions among members on the site at the Members Forum.

    I also offer a twice-monthly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. Join at Newsletter - I look forward to having you as a subscriber.

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