Pattern Day Trader Rule
Over the years, many questions have been posed about the Pattern Day Trader Rule. One of the most intriguing is the extent to which the rule applies to futures. The major reason for these questions is the fact that there are many people who do not understand the Pattern Day Trader Rule very well. Additionally, not everyone is certain that a relationship exists between the rule and Futures day traders.
To answer this question, it is important to gain an understanding of some key areas. Once these are covered, the answer becomes a conclusive one.
The Financial Industry Regulatory Authority (FINRA
FINRA is a US based regulatory body that is involved in the regulation of exchange markets and brokerage firms. Prior to the existence of FINRA, the responsibility of such regulation fell under the portfolio of the National Association of Securities Dealers (NASD).
The mission of FINRA is to ensure that investors are protected. It does this by setting and enforcing policies that ensure transparent and fair operational practices by the securities industry. One such form of enforcement is the routine inspection of all regulated institutions. The areas of options, futures, corporate bonds, and equities are regulated by FINRA.
The Pattern Day Trader Rule was imposed by FINRA on traders that meets certain requirements, which are outlined below.
Who is a Pattern Day Trader?
Now that you are familiar with the regulatory body that put the rule in place, there is now the matter of who the rule applies to. Based on FINRA Rule 4210, a Pattern Day Trader is one who completes at least four round trip trades within five successive business days. Round trip trades refer to the purchase and sale of shares within the boundaries of market open and market close. This means that you can either buy then sell the same stock in a day, or that you can sell then buy the same stock in a day. Note that round trip trades are also known as day trades.
Apart from the quantity requirement mentioned, the total number of day trades made over the five-day business period must be at most 6 percent of total trades for that period. Furthermore, a Pattern Day Trader must have a margin account. Cash accounts cannot be used as a substitute.
How a Margin Account Works
A margin account is a brokerage account that gives the account holder the ability to purchase financial products such as stocks, options, and futures that have a value beyond that of the account. The source of the additional funds is the broker, which means the arrangement is treated as a loan. Since the customer is making use of loaned funds, profit and loss become magnified based on the performance of the purchased assets. This means the possibility exists to generate significant revenue, and the possibility also exists to lose even more than the amount of funds present in the account. Therefore, it is advised that margin accounts are used by expert investors who not only understand how trading with margin works, but also understand the additional risks of investing in this way.
The excess amount provided depends on the ratio arrangement of the loan. For example, if a margin account were to have a 4:1 ratio, the customer could make purchases of up to four times the amount present in the account. Therefore, a margin account with $5,000 allows the account holder to make purchases of up to $20,000 if such a ratio is in effect.
Margin accounts are susceptible to what is known as a margin call. A margin call is a requirement by a broker for the investor to bring an account to a certain margin. This is usually as a result of a broker’s revision of the value of collateral based on external factors. Investors must get to the required margin via cash payment, disposal of securities, or by providing additional collateral.
Pattern Day Trader Rule
Now that the concept of a Pattern Day Trader has been completely covered, the next step is to understand the provisions that form the rule. According to FINRA regulations, the stipulations are:
- A Pattern Day Trader must ensure a minimum equity of $25,000 is maintained on any day trading is to occur. This minimum must be present before any day trades take place.
- The account that the customer uses must be a margin account. The rule cannot be applied to regular cash brokerage accounts.
- A five-day period is granted for meeting margin call. If this is not met, day trading is prohibited either until it is met, or until 90 days have passed.
Are Futures Affected?
With all the important terms out of the way, the focus can now be put on futures and what the Pattern Day Trade rule means for them.
A future is a transaction contract that is established for fulfillment on a future date, but it is based on current information. A buyer agrees to purchase an item from the seller on the date set, at an agreed price. The buyer does this anticipating an increase in the price of the item, which means that savings are derived. This contract allows both buyer and seller to remove any uncertainty surrounding the sale price and so budgets can be completed definitively.
In the context of trading futures, investors look at charts and make predictions on the value of securities. They then establish futures contracts based on these predictions.
Futures Day Traders do not fall under the category of Pattern Day Traders. This is because of the following key differences in day trading of futures:
- There is no $25,000 threshold requirement necessary for futures day trading. Margins are set by the futures broker and the Futures Clearing Merchant (FCM)
- The exchange determines overnight margins.
Based on the information provided, futures are not affected by the Pattern Day Trader rule. There are a couple requirements that are not met by Futures Day Traders and so they are not restricted by the stipulations of the rule. In fact, the definition of the term Pattern Day Trader is not even mentioned in futures trading.