Is there a pattern to your trades?
Anyone trading options knows how little effort it takes to build up a healthy volume of transactions. But you should be aware of one rule that could inhibit your ability to trade options too often in a margin account.
In the past, day trading represented the wild west of the market. It was possible for day traders to move in and out of positions within the trading day and end up with no open positions. Margin is calculated as of the ending positions in the trading day; this meant it was possible to trade on large volume with little or no cash at risk, meaning no margin requirements. It also meant huge risks for brokers.
Trading on extreme leverage is attractive, but it is not the only motive for day trading. Many traders believe that the risk of price gaps between today’s close and tomorrow’s open are simply too great; day trading enables traders to close out positions during the trading day, avoiding this risk altogether. Even so, if you want to day trade, you could fall into the definition of a “pattern day trader.”
Entry and exit decisions are based on momentum, chart patterns, and other technical strategies. Whichever strategy employed, the theme to day trading is that positions are opened and closed before the trading day’s end. This problem, at times representing unacceptable risks to brokers as well as to traders, is what led to the enactment of new rules concerning so-called pattern day traders.
By definition, a day trade is when you buy-to-open and sell-to-close or sell-to-open and buy-to-close the same option within the same market day. A pattern day trader is when this action is repeated four or more times within five consecutive trading days using a margin account. If you fall into this definition, you must maintain at least $25,000 in equity balances (cash and securities) in your margin account. This balance has to be on hand before you can continue any day trading. You can also be labeled a pattern day trader by your broker if your broker believes there is a strong likelihood that you will day trade.
One exception: If your day trading is lower than 6% of the total number of trades you make in the five-day period, then you are not considered a pattern day trader. So, high-volume traders can escape the rule under this provision.
Once you have been labeled a pattern day trader, you will need to maintain at least a $25,000 equity value in the account. If your account falls below $25,000, it will be frozen from day trading until the account is restored to the minimum equity requirement of $25,000.
Example of day trading:
Anyone trading options knows how little effort it takes to build up a healthy volume of transactions. But you should be aware of one rule that could inhibit your ability to trade options too often in a margin account.
In the past, day trading represented the wild west of the market. It was possible for day traders to move in and out of positions within the trading day and end up with no open positions. Margin is calculated as of the ending positions in the trading day; this meant it was possible to trade on large volume with little or no cash at risk, meaning no margin requirements. It also meant huge risks for brokers.
Trading on extreme leverage is attractive, but it is not the only motive for day trading. Many traders believe that the risk of price gaps between today’s close and tomorrow’s open are simply too great; day trading enables traders to close out positions during the trading day, avoiding this risk altogether. Even so, if you want to day trade, you could fall into the definition of a “pattern day trader.”
Entry and exit decisions are based on momentum, chart patterns, and other technical strategies. Whichever strategy employed, the theme to day trading is that positions are opened and closed before the trading day’s end. This problem, at times representing unacceptable risks to brokers as well as to traders, is what led to the enactment of new rules concerning so-called pattern day traders.
By definition, a day trade is when you buy-to-open and sell-to-close or sell-to-open and buy-to-close the same option within the same market day. A pattern day trader is when this action is repeated four or more times within five consecutive trading days using a margin account. If you fall into this definition, you must maintain at least $25,000 in equity balances (cash and securities) in your margin account. This balance has to be on hand before you can continue any day trading. You can also be labeled a pattern day trader by your broker if your broker believes there is a strong likelihood that you will day trade.
One exception: If your day trading is lower than 6% of the total number of trades you make in the five-day period, then you are not considered a pattern day trader. So, high-volume traders can escape the rule under this provision.
Once you have been labeled a pattern day trader, you will need to maintain at least a $25,000 equity value in the account. If your account falls below $25,000, it will be frozen from day trading until the account is restored to the minimum equity requirement of $25,000.
Example of day trading:
- 8/18 10:10 AM BTO AUG-21 TSLA 1900 Call
- 8/18 10:50 AM STC AUG-21 TSLA 1900 Call
This is a day trade. The position was opened and closed in the same trading day.
Example of not day trading:
- 8/17 3:50 PM BTO AUG-21 TSLA 1900 Call
- 8/18 10:50 AM STC AUG-21 TSLA 1900 Call
This is not a day trade. The position was opened and closed on two different trading days.
Example of Pattern Day Trading:
- 8/13 Opened and closed an AMZN Put
- 8/13 Opened and closed a GOOG Call
- 8/17 Opened and closed a BKNG put
- 8/18 Opened and closed a TSLA call
This is pattern day trading. There have been four day trades in a five trading day period. Trading days do not include weekends for stock/index/ETF options. If instead of taking the TSLA call on 8/18, the position was day traded on 8/21, this would not have been classified as pattern day trading. This is because the fourth day trade, TSLA, would have been over five business days away from the first day trade on 8/13. See below:
- 8/13 Opened and closed an AMZN Put
- 8/13 Opened and closed a GOOG Call
- 8/17 Opened and closed a BKNG put
- 8/21 Opened and closed a TSLA call
This is not pattern day trading. Assuming no day trades were placed prior to 8/13.
The pattern day trading requirements is one of those unexpected surprises many traders discover in their margin accounts. The rules are easily understood in hindsight, but unfortunately, they are likely to come to your attention only after you fall into the zone in which they kick in and apply to you.
Individual brokers may have more strict rules regarding pattern day trading. For example, one broker may view the opening and closing of a vertical debit spread as one day trade, while another broker may view the same action as two day trades, since a spread has two different options. It is always important to contact your broker to understand how their day trading rules apply to you and your account. They will also have a record of your current day trades. If it is posted on your platform, make sure you know how to locate the day trade count if you intend to avoid being labeled a pattern day trader and are looking to stay at three day trades or lower in a five trading day period.
