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Pattern Day Trading – What it is and Why It Is Important to Know the Guidelines

A pattern day trader is defined by the Financial Industry Regulatory Authority (FINRA) as anyone who executes four or more day trades in a margin account within a period of five business days.

The number of day trades should also constitute more than six percent of the customer’s total trading activity for the same five business day period.

This is the minimum requirement to be classified as a pattern day trader; yet some broker-dealers have a broader definition for those who meet this classification. This classification has been put in place in order to discourage excessive trades.

Pattern Day Trade Rule

FINRA rules dictate that pattern day traders must have a minimum of $25,000 cash and securities in their accounts and are only allowed to trade in margin accounts. This minimum equity is required to be in the account before day-trading activities commence. When the balance falls below $25,000, the customer is not permitted to trade until it is restored to the minimum $25,000 level, also known as the pattern day trade rule.

4:1 Leverage

Although these requirements exist for day traders, there are benefits such as 4:1 leverage or the ability to trade up to four times the customer’s maintenance margin excess, also known as Day Trading Buying Power. Non-pattern day trading accounts only get 2:1 leverage. Although leverage can help skilled day traders gain profits faster, the opposite is true for losses which also accumulate more quickly.

Margin Calls and Restrictions

A day trading margin call occurs when day-trading buyer power limitations are exceeded and so the broker demands an increase in the account’s equity. When a day trading margin call occurs, the trader has up to five business days to deposit funds to meet it. During this time, the day trading account will be restricted to two times the maintenance margin excess until the margin call is met. If the margin call is not met by the fifth business day, the account is further restricted to a cash only trading basis until the margin call is met or for 90 days.

Pattern Day Trading Alternatives

Pattern day trading has several alternatives for those who would prefer to avoid the $25,000 minimum requirement. Making just three day trades within a five business day period will avoid the day trader classification, but this amounts to less than one trade per day. Swing trading is an alternative that involves trading based on trends that occur over a period of multiple days or weeks rather than single day trends, thus allowing for fewer required trades.

Also, cash accounts avoid the pattern day trader rule because the rule only applies for margin accounts or trading using borrowed funds. Cash accounts come with their own pros and cons, advantages include the avoidance of margin fees, avoidance of the PDT rule and lower risk through use of one’s own funds. Disadvantages include lower buying power due to a lack of leverage and the inability to short stocks.

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