Understanding day trading: The role of the pattern day trading designation

Have you ever bought stock and sold it on the same day? If so, you made a day trade. Day trading is a strategy that involves quick decision-making and market analysis to capitalize on short-term price movement.

What does this look like in practice? As an example, you may learn that a company reported some bad news after the market closed yesterday. You think the company’s stock price will drop significantly at the market open – and that traders will quickly oversell the stock. It’s a solid company, though, and you think the stock price will recover quickly. You buy the stock in the morning and sell it that afternoon at a higher price, reaping a tidy profit.

Making this kind of trade once in a while won’t raise alarms for the Financial Industry Regulatory Authority (FINRA), the industry self-regulatory organization that sets rules for its member firms. But if you’re making day trades more frequently, your brokerage could flag you as a pattern day trader, which comes with certain implications.

In this article we’ll cover what pattern day trading is, what the requirements are for doing this kind of trading and when it may be advisable that someone pattern day trade along with the risks involved.

What is a pattern day trader?

FINRA currently considers you a pattern day trader if you execute four or more day trades within five business days and those day trades constitute more than 6% of your total trades in that same period.

When this occurs, your broker will flag your account and place it under ongoing restrictions. These restrictions are put into place to discourage people from trading excessively, which can lead to extreme losses and potentially even market instability.

Is pattern day trading considered high risk?

The inherent risk in pattern day trading makes it a strategy that may be more appropriate for experienced investors. Sure, same-day trades can result in profits, but no one – not even Wall Street professionals – have perfect stock-picking records. The more frequently retail traders trade, the more likely it is that their winning average will go down. Further, profits can also be reduced by transactional fees and tax consequences. Per FINRA, the majority of day traders lose some or all of their investments with borrowed money.

How is day trading a strategy?

If you’ve studied the stock market, have a disciplined approach to trading and believe you can make more profitable day trades than unprofitable ones, then day trading could be a lucrative way to invest.

However, regardless of your qualifications, if your day trading results in you being designated a pattern day trader, you may add to the risk of an already risky strategy – as well as be subject to stricter regulatory oversight than other trading methods. If you engage in pattern day trading, you’ll be classified as a pattern day trader by your broker even if your trading activity changes, and when you’re classified as a pattern day trader, you’ll have to satisfy certain requirements.

Pattern day trading requirements

Before investors start pattern day trading, they’ll need to meet certain requirements and be aware of best practices. Let’s consider some of these.

You may need a margin account

To place day trades, you’ll likely need to open a margin account with your broker. You can theoretically trade with a cash account, but you’ll run the risk of having a cash trading violation, such as freeriding, if you use unsettled funds to trade.

Margin accounts allow you to borrow money against the value of your holdings, either to buy securities when you don’t have enough cash on hand or to borrow securities to sell to other investors in a transaction called a short sale. Many day trades require margin because they may not have enough cash in their brokerage account to fully fund the trades they want to make.

Margin traders are required or subject to:

You may need to maintain a minimum account balance

You currently must have the $25,000 minimum in your account before making any trades on margin. To ensure traders don’t owe more money than they can repay if their trades lose value, FINRA requires that pattern day traders have at least this amount of equity in their account before engaging in any day-trading activity. This is higher than the minimum equity for investors who aren’t designated pattern day traders.

For example, if you have $60,000 worth of stock with a $30,000 margin loan, you have $30,000 in equity. If your $60,000 portfolio drops more than $5,000, you will have fallen below the FINRA threshold, and your broker may restrict your trading activity until you’ve deposited enough money to return to the $25,000 minimum.

As a requirement, you can’t exceed your buying power

Pattern day traders need to be careful not to trade in excess of their “day-trading buying power” – usually four times the amount in their account that exceeds the minimum maintenance margin after the previous day’s close of business.

What if you’re flagged by your broker as a pattern day trader?

If you make more than four day trades in five business days (and those trades constitute more than 6% of your total trades in that same time frame), you may be flagged as a pattern day trader. If you meet the requirements mentioned above, however, you should be able to continue trading without issue.

It’s a different story, though, if you fail to meet the minimum requirements. In this case, your brokerage may suspend your trading account, which could limit your trading to available cash only or even affect your ability to trade in general. If you’re considering becoming a pattern day trader or are concerned you may be labeled as one, review the rules set by your brokerage to make sure you’re in compliance.

What if you don’t want your margin account flagged as a pattern day trading account?

If you don’t want your account flagged as a pattern day trading account, review both FINRA’s rules for what constitutes a pattern day trader and your brokerage’s rules to make sure you trade in a way that doesn’t run the risk of being flagged.

If your account does get flagged and you don’t want to maintain a pattern day trading account, you may be able to ask your broker to remove the flag. However, this is at the discretion of the brokerage and generally can only be requested once.

The bottom line

Day trading can potentially provide fast rewards, but it also comes with significant risk, particularly if you’re designated a pattern day trader. It’s a strategy for truly experienced investors, and those who engage in it need to be up-to-date on requirements to understand the consequences.

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