Primer: Pattern Daytrading

Are you considering pattern daytrading or just getting started? It is important to understand the benefits, risks and rules about pattern daytrading before you begin. Daytrading carries more risk than swing trading or long-term investing because it plays more on human desire for immediate gratification. Translation, it entraps those with limited trading discipline, clear objectives and rules to live by.

Introduction to Daytrading

Daytrading is the buying and selling (or shorting and buying-to-cover) of investments within the same day. Experienced investors and traders that accumulate enough wealth to provide financial security sometime engage in daytrading full-time. Thanks to easy access to zero-commission online brokers, many others now daytrade part time or on a limited basis.

Those who engage in daytrading full time typically close most or all of their positions overnight, engage in a limited number of trades within the day, and conduct research on evenings and weekends when the markets are closed.

Pattern Daytrading Basics

Patterned daytrading is defined by the Securities and Exchange Commission (SEC) as occurring when an account executes more than 3 day trades within a 5-day open-market rolling period. This definition is important as it provides the catalyst for a number of SEC trading rules to kick-in should you exceed this threshold with a given week.

Rules and Provisions for Pattern Daytrading

By SEC regulation, any account that exceeds that 3-trade/5-day rule is marked as a “Pattern Daytrader” account by his or her brokerage. This rule is a regulation that all brokers must follow.

A lot of brokers kindly enable you to place a restriction on a transaction that would cause you to exceed this threshold. It blocks you from executing the 4th trade. Other brokers alert you to the number of “round trip” trades you have completed, but they do not have this blocking feature.

I have also observed differences, to some extent, in the ways in which brokers interpret round trips. Most (rightly) interpret a round trip as all transactions related to a single purchase and subsequent sale, or all transactions related to a single short and subsequent buy. However, I have seen a few that consider each related transaction a separate round trip. For instance, let’s say you buy 5,000 shares of stock X in the morning and sell those shares throughout the day in 500 share lots. This trading activity should be interpreted as a single round trip. However, I have seen some brokers (most rely on automated tools to identify round trips) that incorrectly interpret this as multiple round trips. Thus, read the fine print your broker offers or ask in advance.

To continue trading as a “Patterned Daytrader,” you must maintain a minimum equity of $25,000 in your brokerage account at the open on each day in which you execute day trades. If you daytrade on days where your account value falls below this level, you will receive an alert from your broker indicating that your account is “restricted” (or something to that effect) from day trades until it reaches the $25,000 level (from trading profits or deposits). If you day trade with this restriction in place, you are subsequently alerted that you can only execute trades to close open long positions or to covering short positions for a period of 90 days or until the equity minimum is met. Typically, this restriction means you can’t execute new position orders.

There are a few other details related to SEC pattern daytrading regulations, but they aren’t as pertinent. For instance, you can daytrade with a below-$25,000 account value if the amount of your daytrades falls below a minimum percentage of your trading activity. However, meeting this alternative rule is somewhat impractical if you intend to daytrade routinely.

Removal of “Patterned DayTrader” Tag

Some brokers readily communicate that they offer limited removals of the “patterned daytrader” label; others do offer it but don’t readily communicate that; others don’t offer it.

A removal of this label means the broker rescinds the “pattern daytrader” label on your account and effectively resets it to the point before you violated the 3-trade/5-day rule. Thus, you get a “do over” in following this SEC guideline. By regulation, brokers can actually remove this tag up to three times within a rolling 12-month time period. However, not all brokers will do so. Some indicate a willingness to remove it once as a “courtesy” on the presumption that you mistakenly made the 4th day trade. You can always ask for additional removals and they may be granted to retain you as a client.

***IMPORTANT UPDATE*** FINRA changed rules regarding pattern daytrading, which limit flag removals to just one per the life of an account. This rule means that if you have previously had a flag removed, you can no longer do so. Here is a portion of a memo sent by TDAmeritrade to any account that has held (or still holds) a pattern daytrader flag:

“In response to new Financial Industry Regulatory Authority (FINRA) rules related to pattern day trading, we are updating our policy (which will go into effect on or about September 14, 2021). Because your account was noted for pattern day trading in the past year, we wanted to make sure you’re aware of the change and how it could impact your account.”

Conclusions and Recommendations

The rules about patterned daytrading may seem unreasonable or unnecessary. However, they are intended to ensure that people engaged in this practice have the necessary capital to take on the additional risks. Even if you have the resources, daytrading is not for everyone. Consider your own objectives, strategies, abilities, limitations and challenges as an investor or trader.

Read the fineprint of your brokerage disclosures before engaging in patterned daytrading. Ideally, maintain an account value well above the $25,000 minimum to avoid the risk of falling below it due to fluctuating positions and trading wins and losses.

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