"Pattern Day Trader"

There 3 words are part of the new trading rules that HAVE been approved, and are scheduled to take affect on Sept. 28, 2001.  The rules were proposed by the NYSE and NASD, there was some input from a Senate Committee, and the rules were approved by the SEC on Feb. 27, 2001.  Here is the breakdown of the new rules, First you get more Margin, but that also leads into the new Margin Call rules.  Then we examine what is a Day Trade, and then just how a few trades will qualify you as a Pattern Day Trader.  Once classified as a PDT, you will come find out what the Consequences are, and then I will answer the question of, "Can I just use a Cash Account?"

Finally, I will start examining what Trading Strategies we can look at that will help us once these rules take affect.

Also, you can read the actual notice and rules in PDF format.

In doing my research, I spoke to Michael Gaw, an attorney at the SEC, and also spoke with Susan DeMando, Director, Financial Operations, Member Regulation, NASD Regulation, Inc.

Increased Margin 

It will be up to your broker whether they want to offer you 4X margin, or leave it at the current 2X.  The rules allow up to 4X, but your broker does NOT have to offer that amount to you.  They can be more restrictive, not more lenient than the approved rules.  So, if you have a $10,000 account, instead of $20,000 of buying power, you could be looking at $40,000 of buying power.

This increased margin will apply to all margin accounts, small and large.  You will still need $2000 to open a margin account.

This new rule could be the undoing of more traders than anything else.  Consider this, if you but a stock and set a 5% stop loss on it, and you are buying it on margin, instead of losing 5% of your capital, you now could lose 20% of it.  Here is a real dollars and cents demonstration of how this can happen. (Commissions are not going to be figured into this demonstration)

Cash Account:  You buy 100 shares of XYZ @ $10 = $1000.00 capital.  You set a 5% stop at $9.50.  The price falls and you get stopped out.  100 shares @ $9.50 = $950.00 of capital remaining.

2X Margin Account:  You are going to use that same $1000 to buy XYZ, but with your margin, you can buy twice as much. You buy 200 shares of XYZ @ $10.  You put up $1000 of your capital, and your broker matches that with $1000 of margin for the total purchase price of $2000.00  You set the same stop, and it gets hit.  So there is $1900 from the sale of the 200 shares, FIRST you have to pay back the $1000 of margin to your broker, that leaves you $900 of your capital remaining.  You started with $1000 of your capital, and now only have $900 left, that is a 10% loss of YOUR MONEY!

4X Margin Account:  You can now buy 400 shares of XYZ @ 10, you still put up the same $1000 of your capital, and your broker puts up the remaining $3000.  Same stop is used.  When it is hit, the first thing you have to do out of the $3800 you get from selling 400 shares of XYZ @ $9.50, is to pay back the $3000 to your broker, that leaves you $800 out of the $1000 that you started with.  That is a 20% loss of YOUR MONEY!

And another bad aspect to this, is now you only have $800 left, so with 4X margin your buying power is down from $4000 to $3200, so you can not even buy the 400 shares of XYZ back unless it falls to $8.  So not only does the 4X take away more of your capital on a "small" loss, but it also drastically reduces your buying power.

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Margin Call

The new rules will make margin calls a whole lot more interesting.  Currently a margin call is issued based on a position that is held overnight.  Under the new rules, a Day Trading Margin Call can be issued based on your positions DURING the day.

To find out how a margin call gets issued, you first have to find out how your broker tracks your account.  There are 2 methods that are accepted.  The most lenient is the Time and Tick method.  In this method, you only have to be concerned with OPEN positions.  The other method is TOTAL COMMITMENT. With this method you have to be concerned with ALL of the positions you enter during the day.

Here is how both of these work.  We will use a $30,000 account with 4X margin resulting in $120,000 of buying power, as the example.

Time and Tick:  With Time and Tick, only your OPEN positions are applied towards a margin call.  So, if you buy $100,000 of XYZ, sell it for $100,000 and then buy $100,000 of ZYX, then everything is just fine.  If you buy $80,000 of XYZ and while that position is open, you buy $80,000 of ZYX, then you NOW have a problem, you now have $160,000 in open positions, and that exceeds your $120,000 of buying power, so you would be issued a margin call.

Total Commitment:  This is the one that will get a lot of people into trouble.  You have the $120,000 buying power, and that is the total you can spend on ALL of the positions during that day.  Here are a couple of examples.  You buy $50,000 of XYZ, and then sell it.  You buy $30,000 of ZYX, and you buy $30,000 of YZX.  Then you sell both and call it a day.  You do NOT get a margin call for this day, because the total of your positions was less than your buying power.  50,000 + 30,000 + 30,000 = $110,000, which is less than $120,000 buying power.

Now lets move on to the next day.  You buy $80,000 of XYZ and then sell it, then you buy $80,000 of ZYX and then sell it.  Now you will get a margin call, because your positions exceeded your buying power.  80,000 + 80,000 = $160,000 which is greater than your $120,000 buying power.

To calculate the amount of the margin call, you take the amount of the overage (in both cases above the overage is $160,000) and subtract the amount of your buying power, and divide by the margin level you have.  2X or 4X.  So, 160,000 - 120,000 = $40,000.  This happened on a 4X margin account, so you take 40,000 divided by 4 = $10,000 margin call.

Ok, now you have gotten your Day Trading Margin Call for $10,000.  You now have 5 days to DEPOSIT funds to meet this margin call.  Until you make the deposit, your account is restricted to 2X Margin AND your margin will be based on TOTAL COMMITMENT!  So, on day 2, you still have your $30,000, but now only $60,000 of buying power.  So if you buy $40,000 of XYZ, sell it, and then buy $30,000 of ZYX and sell it, you will get a SECOND Day Trading Margin Call.  40,000 + 30,000 = $70,000, which exceeds your $60,000 of buying power.  70,000 - 60,000 = $10,000 divided by 2 = $5000.  So your day 2 margin call will be $5,000.

If you do not meet your margin call, your account will be further restricted to a Cash Available basis for 90 days, or until the margin call is met.

If you do deposit the funds to meet a margin call, the funds can NOT be withdrawn for 2 days.  So you won't be able to "float" the funds to meet a margin call.

So, to avoid a margin call, YOU have to be aware of your buying power, and what method your margin is based on.

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Definition of a "Day Trade" 

"Purchasing and selling, or selling and purchasing the same security in the same day in a margin account."  This is pretty straight forward and simple.  It does apply to both stocks and options.  The kick in the pants though, is if you buy XYZ, set a stop loss on it, and the stop is hit that same day, that by definition is the buy and sell of the same security in the same day, and there-fore IS a day trade.

To avoid a day trade, you HAVE to hold the position overnight.  It is permissible to hold XYZ overnight, sell the next morning, and then take a new position in XYZ.  But you do have to hold the new position overnight to avoid having it become a day trade.

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Definition of "Pattern Day Trader"  

Here is the most important definition for the small traders.  This is where a lot of people will get caught.

"A Pattern Day Trader is a customer who executes four or more day trades within five business days, unless the number of day trades is six percent or less of their total trades for that period."

Now to break this down to show why it will be so hard for an active trader to NOT become a Pattern Day Trader.

The first part is the key, Four or more day trades in 5 business days.  4 day trades and you are a Pattern Day Trader.  And it does not say in a week, it says in 5 business days.  So you will constantly be in a 5 day period, and each day you will start a new 5 day period.  At first I thought, ok, a simple way to avoid this is to only trade on Tues., Wed., and Thurs.  BUT, when you have a holiday on Mon. then Tues., Wed., Thurs, Fri., AND the next Tues. will make up a 5 business day period.  Trying to keep up with this would be a nightmare.  And eventually you would be bound to make a mistake and would be classified as a Pattern Day Trader.  So, to be an active trader, and to trade as you currently are, you might as well resign yourself to being classified as a Pattern Day Trader. 

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Equity Requirement, and Consequences   

Once you get designated as a Pattern Day Trader, the next rule kicks in.

"A Pattern Day Trader would be required to maintain $25,000 in his or her account on any day in which he or she day trades.

Simply put, your account balance HAS to be $25,000 cash and or equity.

For the large trader that does have over $25,000, you have met this requirement, and can continue on to the next section.  For the small trader with less than $25,000, read on.

You can shed this designation by informing your broker that you will not day trade.  BUT, if you do continue to day trade, your broker MUST classify you as a Pattern Day Trader, and you MUST meet this equity requirement of $25,000.  What if you don't meet it?  Then your broker can (should according to Susan DeMando) CLOSE your account.  They will allow you to make a mistake, but once you show that you are going to continue to day trade, then you can not get out of this designation.  

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Cash Account and existing rules.  

I have been asked about IRA accounts, and the idea of just opening a Cash Account to avoid this whole issue. 

The new rules do not apply to a cash account, and that is because the existing rules are already in place to keep you from actively Day Trading in a cash account.  What you have to watch out for in a cash account is something called "Free Riding", and the penalty for that is a 90 day restriction on the account.

You can look in "Reg T" for more specifics about this, but here is a summation of how the existing rules keep you from actively day trading in the cash account.

When you buy XYZ, the funds are obligated towards that purchase right then.  When you sell XYZ, the settlement date is in 3 days.  So technically, you can not make another trade with those funds until the settlement takes place.  BUT, so many of the brokers have seen the unfairness of this, you pay right away, but have to wait 3 days to get the funds from selling, that they treat the settlement as if it takes place on the day you sell the position.  Not the minute that you sell the position, but the day you sell it.  So, you can NOT use those funds to enter another position that day.  When you use those funds to enter another position, that is when you are guilty of "Free Riding".  So to prevent free riding, you have to treat your positions in the "Total Commitment" manner.  If you have $10,000 in your account, then you could buy and sell $5000 of XYZ and you could buy and sell $4500 of ZYX.  That would give you 2 positions for $9500, and that is below your $10,000 account balance.  

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Trading Strategies  

What can we do about these new rules?

We can not change them, we have to learn the rules, how they will impact us, and be prepared for the changes.

Every margin account could conceivably get the 4X margin.  I know there will be some brokers that won't give that much margin.  And In My Humble Opinion, the traders that push their margin to the limits are just asking for trouble, and will be the first ones to get washed out.  I firmly believe that margin is a tool to be sparingly used.  It does have its benefits, but it does contain considerable risk.  The extra buying power could make a big difference though if you broker insists on using the "Total Commitment" approach on your account.  To actively trade it, you could make many trades that do not use margin, but the sum of all the trades could approach your total buying power.  That would be the smart way to do it in my book.  Because the Day Trading Margin Call requires funds to be deposited into your account to cover the margin call, you will have to monitor your account very closely, especially if you have to live by "Total Commitment".  The "Time and Tick" is much easier to live by, all you have to monitor is your open positions, and ensure they stay within your buying power, that is much easier than tracking the sum of all your positions to ensure the sum does not exceed your buying power.

For the small trader, the designation of "Pattern Day Trader" could be equivalent to a "Kiss of Death", and the job is going to be much harder to avoid this designation.

What strategies do we need to develop?  

The first one I see would be for the small trader, a strategy to allow them to still actively trade, and to be able to avoid the Pattern Day Trader Designation.  I believe that options will play a big role in this.  We will have to work out a strategy that will take the place of the "stop loss order".  One that will control the risk of the position.  The next strategy is one that will lock in a gain if the stock makes a major move during the day you buy it.

I feel that these strategies will also benefit the larger trader, they will reduce risk, and capture gains.  And we will have to work on discipline to follow the strategies, and to manage the account to avoid a margin call.

These strategies will be further explained in the message board and the lessons section as they are developed and tested.

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Here is the (PDF) NASD Notice to Member 01-26 document that explains what the changes are.  NOTE: you must have Adobe Acrobat installed to be able to read the notice.  

This link will take you to the 11 pages that are in the (PDF) Federal Register.  NOTE: you must have Adobe Acrobat installed to be able to read the details of the rules.

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