A pattern day trader is a trader who makes four or more qualifying day trades in a five-day period.
To qualify as a pattern day trader, the individual must meet two additional criteria. The person must use the same margin account for the qualifying trades, and the number of trades must make up more than 6% of the trades made from the individual’s margin account for the business day. Brokers are required to designate individuals as pattern day traders if they have reason to believe the person will engage in qualifying activity. When this happens, the trader must meet certain guidelines to continue trading.
Pattern day trading is one type of day trading, which means the trader buys and sells – or sells and buys – a security in a single-day trading session. For example, a trader may buy 100 shares of a stock first thing in the morning because they anticipate a positive earnings report that day. If the stock’s value does increase after the release of the report, the trader may sell those shares and pocket the profit. Conversely, the trader may sell 100 shares of stock first thing in the morning because they expect a poor earnings report that will lower the stock’s price. The trader can then buy the stock back at the end of the day, with plans to sell at a later date when the price increases.
A pattern day trader does this at least four times in a five-day period. These traders often borrow money or shares from a broker to complete these deals, a practice known as shorting. Using leveraged capital gives the trader access to more money than they may have available in their margin account. The trader repays what they borrowed after completing the transaction. This is one reason why pattern day trading is riskier than other forms of trading securities. When stocks don’t do what traders expect they will do, they stand to lose the potential profit from the sale and the money they put up, along with the obligation to replace what they borrowed from the broker.
People engaged in pattern day trading can potentially earn large amounts of money in a short period of time. For many people, this is the greatest reward of the practice. However, some also enjoy the fast-paced environment and mental demand required to research and monitor stock performance to predict which ones will provide the greatest financial benefit. In short, it can be exciting to work at a whirlwind pace, especially when the trade pays off.
For others, the rewards do not outweigh the risk – and pattern day trading is risky. Pattern day traders often leverage capital to purchase securities. Trading with borrowed assets can multiply the potential loss for the trader if the security’s price does not move as predicted. For this reason, pattern day traders must avoid making emotional decisions about which securities to buy and sell.
In the end, day traders win some and lose some. No one can predict how every stock will move, and even the best traders eventually choose a stock that loses – sometimes in big ways. The more trades they execute, the greater the chance they have of choosing a loser.
To be a pattern day trader, the individual must earn the designation by completing at least four day trades within five business days. They also need a margin account. Using a cash account to engage in pattern day trading is a good faith violation, which happens when you buy and sell a security using unsettled funds. However, even if using a cash account was permissible, it may not always work for pattern day trading because it may not have enough cash available to complete the transactions the trader wants.
The margin account must always have at least $25,000 of equity available. This equity can come from cash and securities. When the amount of equity falls under this threshold, the trader will not be able to complete any trades from this account until the trader replenishes it. This serves two purposes. It ensures the trader has the funds to complete the transactions they make. It also protects the trader from making too many deals they may not be able to afford.
FAQs
Yes, pattern day trading is a legal practice. However, the individual and the broker must follow the rules set to regulate pattern day trading. This includes designating the trader as a pattern day trader and meeting the minimum equity amounts in the margin account.
Pattern day traders must keep at least $25,000 equity in their margin accounts to ensure they can cover all the trades they make using this risky practice. Sometimes the trades do not settle before the end of the day. Having the equity in place ensures that money is available in the account to cover all of the trades as they go through.
When an investor uses a cash account, they can only spend what they actually have in the account. To complete the trade, they must have enough money in the account to cover the entire transaction. A margin account gives the investor the ability to borrow money. In this way, they can buy securities that cost more than they actually have on hand, which increases the risk and the potential reward.
The pattern day trading rule is a phrase some people use when they refer to the guidelines used by the Financial Industry Regulatory Authority, or FINRA, to determine if someone is a pattern day trader. Specifically, they reference the number of trades a person must complete to receive the pattern day trader designation and the minimum account balance requirements this designation triggers.
