Is Pattern Day Trading Illegal? The Rules and Penalties

Day trading involves the rapid buying and selling of securities within the same trading day, aiming to profit from short-term price movements. While not illegal, it is subject to specific regulations, particularly for those who frequently engage in such activities using margin accounts. These regulations are designed to manage the inherent risks associated with high-frequency trading.

Understanding Pattern Day Trading

A “day trade” is defined as the purchase and sale, or the sale and purchase, of the same security on the same day in a margin account. This includes any security, such as stocks and options. An individual is identified as a “pattern day trader” under FINRA Rule 4210 if they execute four or more day trades within five business days in a margin account. This designation applies if the number of day trades represents more than 6% of their total trades in that same five-business-day period. These rules specifically apply to trading activities conducted within a margin account. Firms can also designate someone as a pattern day trader if they have a reasonable belief that the individual will engage in such trading.

The Pattern Day Trader Rule

Once an individual is identified as a pattern day trader, specific financial requirements come into effect. The primary obligation is to maintain a minimum equity of $25,000 in their margin account on any day they engage in day trading. This required minimum equity must be present in the account before any day-trading activities commence. If the account’s equity falls below this $25,000 threshold, the pattern day trader will not be permitted to execute further day trades until the account is restored to the minimum equity level.

Pattern day traders also have a specific day-trading buying power, generally up to four times the maintenance margin excess. Maintenance margin excess represents the amount by which the equity in the margin account exceeds the required margin. Firms may impose higher equity requirements than the minimum specified in the rules. This framework aims to ensure that traders have sufficient capital to cover potential risks associated with their elevated trading activity.

Consequences of Rule Violations

Failing to adhere to the pattern day trading rules carries specific repercussions for traders. If a pattern day trader’s account equity drops below the $25,000 minimum, a day-trading margin call will be issued by the brokerage firm. Traders have up to five business days to deposit additional funds or eligible securities to meet this call. The funds used to meet such a call must remain in the account for two business days following the deposit.

During the period a margin call is outstanding, the account’s day-trading buying power may be restricted, often to two times the maintenance margin excess. If the day-trading margin call is not met within the five-business-day deadline, the account will face further restrictions. This results in the account being limited to closing-only transactions, meaning new positions cannot be opened. The account may be frozen for 90 days, preventing both opening and closing trades, or until the call is met.

Strategies to Avoid or Manage Pattern Day Trader Status

Traders seeking to manage or avoid the pattern day trader designation have several practical approaches. One method involves conducting trades in a cash account rather than a margin account, as the pattern day trader rule applies exclusively to margin accounts. While cash accounts are exempt from this rule, they require funds to settle before they can be reused for new trades, which takes two business days for stocks. This settlement period means that the buying power in a cash account is limited to settled funds, which can restrict rapid, consecutive trading.

Another strategy involves carefully monitoring the number of day trades executed within the five-business-day rolling period. By limiting day trades to three or fewer within this timeframe, individuals can avoid being classified as a pattern day trader, provided their account equity is below $25,000. For those who wish to day trade frequently, maintaining equity significantly above the $25,000 minimum in a margin account allows for unlimited day trading without triggering restrictions. Some traders also consider using multiple brokerage accounts or exploring alternative markets not subject to the rule, such as futures.