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 too often in the same option and in the same stock.

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.

For some traders, the idea of day trading was a path to easy riches with no risk. It was the fad of the day and it worked — until the market turned and fell, meaning a lot of portfolios based on accumulated day trades collapsed. And as most traders know, market prices tend to fall more rapidly than they rise.

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, you are a pattern day trader if you buy or sell a security within the same day, and follow this pattern on the same security four or more times within five consecutive trading days. 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, once you reach that threshold. This rule, called SEC Rule 2520, was put into effect on February 27, 2001.

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.

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.

Being identified as a pattern day trader is only one-half of the problem. The other half will be getting the stigma removed. You have to write letters promising to not repeat the pattern and, if you do, you face trading suspension. Your broker does not have to remove this label, and even after they do, if you repeat the trading pattern, you could have your account suspended or even closed. The hassle of being labeled as a pattern day trader goes far beyond the collateral requirements.