Sunday, January 19, 2020

What is a Pattern Day Trader?



Intraday trading can be a good way to shore up your income. But if you’re engaging in intraday trading for beginners, it’s important to get a clear picture of how it all works.

Day traders in the United States (US), for example, are familiar with the term ‘pattern day trader’. This is a regulatory designation introduced by the Financial Industry Regulatory Authority (FINRA) in the US to prevent individuals from trading excessively. This is important because pattern day traders engage in margin trading—that is, they borrow money from the broker to carry out trades through their margin account.

Whether you are interested in online share trading or trading other kinds of securities, it helps to understand the basics of margin trading. A closer look at the characteristics of pattern day traders could provide some insights in this regard.


Pattern day trader: The basics


A stock market trader who carries out four (or more) day trades within a period of five consecutive business days is termed a pattern day trader, provided certain conditions are met:

  • The day trades are carried out through a margin account and positions are never held overnight.
  • The day trades represent over 6% of the total trading activity in the margin account over the five-day period.

NASD Rule 2520 outlines the regulations pertaining to day traders.


Curbs on pattern day traders


FINRA has placed certain checks on pattern day traders to reduce the risks inherent in intraday trading. The main restrictions are listed below:

Minimum account balance: Pattern day traders are obliged to maintain a minimum balance of USD 25,000 in their trading accounts. The amount does not have to be wholly in cash though. It could be a combination of cash and stock holdings.

If the balance dips below USD 25,000, the trader will not be allowed to carry out any trades. 





Margin call: At times, the broker may place a margin call. The broker does this to alert the trader that the account balance has dropped below the minimum limit. This may occur if, for example, the value of some stock holdings in the trader’s account falls below a certain level.

Upon receiving a margin call, the trader will have to address the issue within five business days. Trading will be restricted to twice the maintenance margin until the account balance threshold is met.

If the trader does not respond within five business days, the broker may place restrictions on the trading account. For instance, the trader may be relegated to a cash-restricted status for up to 90 days. This means the trader will have to carry out all trades using cash. No trading on margin will be permitted.

These restrictions are set down by FINRA. However, some brokerage firms may have more stringent rules in place.


Why are these curbs necessary?


An essential aspect of the pattern day trader is that they trade through a margin account. In other words, they use the money borrowed from the broker to execute trades. Trading with borrowed money naturally carries a degree of risk.

As a pattern trader, you get a margin of 25%. This means the broker will lend you 75% of the cost of securities as you trade. In contrast, standard traders are permitted to borrow only around 50%. The margin advantage is provided to pattern day traders because they close their positions before the markets close for the day. So, the broker ends up lending money for a shorter time.


Summing up


Margin trading, as you’ve seen in the case of pattern day traders, is a big part of online share trading. But when it comes to intraday trading for beginners, it is advisable to start small and keep your borrowings manageable. It may help to open an account with a brokerage like Kotak Securities that offers portfolio tracking tools and extensive educational resources. With some practice, making the right day trading decisions should come easily to you.


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