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Trading Options And The Pattern Day Trader Rule
The Bulls And Bears Duke It Out In Daily Trading
Day Trading Options
There are dozens, if not hundreds, of ads and advertisements for options trading. Everyone and their brother seems to have a customizable platform with all the latest trader tools at your fingertips. Undoubtedly there is money to be made in trading stocks and options but there is even more potential for great losses. The ads always glamorize the late night trader or the one sitting at home enjoying a cup of coffee on sunday morning while placing his orders. What they don't do is show you is the other two guys who are pulling their hair out because their accounts are frozen or worse.....empty.
The Risk Of Day Trading
Day trading is extremely risky because of the volatile nature of stocks. Many day trades are based on very small market movements that can easily turn against the trader. Some are also based on inflated market prices, like during the technology bubble of the late nineties and the housing bubble of 2007-08. Highly leveraged accounts like those trading options are susceptible to sudden swings in the market and could easily leave an unseasoned, or a seasoned, trader out in the cold.
What Is The Pattern Day Trader Rule?
The Pattern Day Trader Rule was adopted by the SEC following the Tech Bubble of the late 1990s. During the time leading up to the bubble and its subsequent bursting many traders, investors, holding companies and the like leveraged their accounts, speculating on the growing tech and dot com industry. Much of the leverage was in the form of margin accounts and some were in margin accounts being backed by other margin accounts, otherwise known as Cross Guarantees. Cross guarantees are when the same capital is being used to back more than one margin account. This means that some highly leveraged accounts were being backed by promises. Eventually the house of cards came crashing down and the prices of stocks came down with it. This caused some big losses in some heavily leveraged accounts and resulted in a massive wave of margin calls that wiped out many traders.
The Pattern Day Trader Rule - Any individual who buys and then sells the same security in the same day three or more times in a five day perios is considered to be a Pattern Day Trader. Individuals tagged as a Pattern Day Trader (PDT) will be required to maintain a margin account (along with some other stipulations) with a minimum balance of $25,000.
- This applies to any trades including stocks or options. For some reason it does apply to futures or forex at this time. It also does not apply if your day-trading activity is less than 6% of your total trade activities in the same five day period (for people with very large accounts).
- A Day Trade is any trade opened and closed on the same calendar day. Selling short in premarket and then buying to cover in the after market counts as a day trade. A day to day trade, such as buying in the afternoon and then selling in the morning does not count.
- The five day period means consecutive trading trading. It does not take weekends into account. A day trade made on Friday and a day trade made on Monday are considered to be have been made on consecutive trading days.
- The rule states four or more times in a five day period but in effect it is three. If you make three day trades in a non-margin account you may find your account frozen or suspended by your brokerage until you comply with the rules.
- The margin account lets you trade up to four times the maintenance level of the account. A basic $25,000 account can trade up to $100,000 in one day.
- If you go over your limit, which is set each day based on the account balance minus any unsettled trades, you will be issued a margin call requiring you to meet the maintenance limit within 5 business days. In some cases you may have only three days to meet the call.
- There are no cross guarantees. Each day trading account must maintain its margin minimum independently.
Avoid The PDT Rule By Trading Futures
Futures trading is not governed by the pattern day trader rule. You will still have to maintain a margin account in order to trade futures but the requirements are much lower. A basic margin account with a cash balance of less than $5000 will be able to trade futures on most platforms. Keep in mind though that not all platforms allow futures trading and that futures trading involves significant risks of loss. It is possible to lose more than your original investment with a bad futures trade.
The Downside Of The Pattern Day Trader Rule
- Margin Account Minimums - There are many capable traders out there with the ability, knowledge and discipline to day trade options but are kept out of the market due to PDT limitations. Not every savvy trader has $25,000 they can jut put into a margin account and let sit. The $2,000 minimum for regular margin accounts would have been good enough provided the online brokerages actually regulated their account holders.
- Why shouldn't we be allowed to day trade on a cash only basis? Not everyone wants to take on the added risk of trading on margin. Allowing them to trade on a cash only basis, provided they do not break the free riding prohibitions, would add liquidity and increase market participation.
- You have to maintain the account with $25,000. All the time. And it's a minimum, as soon as you buy a position and pay a commission you are in danger of a margin call. To effectively day trade you need to have more than $25,000 in your account. This is true for most brokers but may vary from platform to platform