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Sunday, November 10, 2013

Pattern Day Trading regulations - NASTY business

I haven't posted a lot lately because my trading fund has been basically shut down by a wonderful little SEC regulation for 90 days. It has brought me to my knees, because I'm not allowed ANY new trades and can only close existing trades OR until I bring the account up to $25K. It is a disgusting regulation that targets the small trader with the smallest funds and is UNFAIR. It's been passed by Congress to protect the small trader from herself. Big Brother. Thank you very much.

Oh! I've gotten some emails asking me WHY I day trade! Let me be clear...I do NOT day trade. I got CAUGHT in this lousy regulation by simply doing a few earnings plays (selling premium and buying it back when it surprisingly went into profit BEFORE earnings, and instead of holding it overnight, I bought it back for a profit ON THE SAME DAY. Without knowledge of this regulation, I was "day trading" four trades without any intention to day trade at all. Think or Swim should give a warning on said trades (I understand E Trade does) but doesn't.

To explain the damned reg, I've copied and pasted from Wiki and other websites. Bolded sentences, mine.

WHAT IS IT?

Pattern day trader is a term defined by the U.S. Securities and Exchange Commission to describe a stock market trader who executes 4 (or more) day trades in 5 business days in a margin account, provided the number of day trades are more than six percent of the customer's total trading activity for that same five-day period. As the trader is exposed to the danger of day trading and intraday risks and potential rewards, it is subject to specific requirements and restrictions. A FINRA (NASD) rule that applies to margin, but not to cash accounts.

A pattern day trader is subject to special rules. The main rule is that in order to engage in pattern day trading you must maintain an equity balance of at least $25,000 in a margin account. The required minimum equity must be in the account prior to any daytrading activities. Three months must pass without a day trade for a person so classified to lose the restrictions imposed on them. Pursuant to NYSE 432, brokerage firms must maintain a daily record of required margin.

A non-pattern day trader (i.e. someone with only occasional day trading), can become designated a pattern day trader anytime if they meet the above criteria. If the brokerage firm knows, or reasonably believes a client who seeks to open or resume an account will engage in pattern day trading, then the customer may immediately be considered a pattern day trader without waiting 5 business days.

WHAT's A DAY TRADE ANYWAY?

If you open and close a trade in the same day, it is a day trade. If you buy in one trade and sell the position in 3 trades, that is still considered 1 day trade. Three more day trades in the next 4 business days will freeze your account (you can only close existing positions) for 90 days, or until you get $25,000 cash into your account, whichever comes first. This also applies to options. Forced sales of securities- for instance through a margin call- still count towards the day trading limits.

ISN'T THIS RULE HELPING TRADERS FROM RISK?

While all investments have some inherent level of risk, day trading is considered by the SEC to have significantly high risk. The Securities and Exchange Commission (SEC) makes new amendments to address the intraday risks associated with day trading in customer accounts. The amendments require that equity and maintenance margin be deposited and maintained in customer accounts that engage in a pattern of day trading in amounts sufficient to support the risks associated with such trading activities. In addition, the SEC believes that people whose account sizes are less than $25,000 may represent less sophisticated traders, who may be more prone to being misled by advisory brokers and/or tipping agencies. This is along a similar line of reasoning that hedge fund investors typically must have a net worth in excess of $1 million. In other words, the SEC uses the account size of the trader as a measure of the sophistication of the trader. THIS IS SO WRONG! This rule essentially works as a stop-loss on an unsophisticated traders account, disabling the traders ability to continue to engage in day trading activities.

One argument made by opponents of the rule is that the requirement is "governmental paternalism" and anti-competitive in a sense that it puts the government in the position of protecting investors/traders from themselves thus hindering the ideals of the free markets. Consequently, it is also seen to obstruct the efficiency of markets by unfairly forcing small retail investors to use Bulge bracket firms to invest/trade on their behalf thereby protecting the commissions Bulge bracket firms earn on their retail businesses.

Another argument made by opponents, is that the rule may, in some circumstances, increase a trader's risk. For example, a trader may use 3 day trades, and then enter a fourth position to hold overnight. If unexpected news causes the equity to rapidly decrease in price, the trader is presented with two choices. One choice would be to continue to hold the stock overnight, and risk a large loss of capital. The other choice would be to close the position, protecting his capital, and (perhaps inappropriately) fall under the rule, as this would now be a 4th day trade within the period. Of course, if the trader is aware of this well-known rule, he should not open the 4th position unless he or she intends to hold it overnight. However, even trades made within the three trade limit (the 4th being the one that would send the trader over the Pattern Day Trader threshold) are arguably going to involve higher risk, as the trader has an incentive to hold longer than he or she might if they were afforded the freedom to exit a position and reenter at a later time. In this sense, a strong argument can be made the rule (inadvertently) increases the trader's likelihood of incurring extra risk to make his trades "fit" within his or her allotted three-day trades per 5 days.

The rule may also adversely affect position traders by preventing them from setting stops on the first day they enter positions. For example, a position trader takes 4 different positions in 4 different stocks. To protect his capital, he sets stop losses on each position. There is then unexpected news that adversely affects the entire market, and all the stocks he has taken positions in rapidly decline in price, triggering the stop losses. The rule is now triggered, as 4 day trades have occurred. Therefore, the trader must choose between not diversifying and entering no more than 3 new positions on any given day (limiting their diversification, which inherently increases their risk of losses) or choose to pass on setting stops due to fear of the above scenario, a decision which also increases the risks to higher levels than it would be present if the four trade rule were not being imposed.

I'm mad as hell, but there's not a damned thing I can do about it.

Oh, good, here's a little rant by Tom Sosnoff about the ludicrous Big Brother controls around the little trader, including the rant of my own above. Tom Sosnoff - What Else Ya' Got?

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9 comments:

  1. Try this: When the market is in a rapid decline buy Puts instead of closing your position. If the whole market is declining buy Puts on the SPY.

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  2. I was closing winners, not losers. Didn't realize said regulation existed at the time. See my addendum (in blue) above. Thanks.

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  3. I don't know specifically what your trades were, but assuming that you were Long a Call or Put, you could convert the trade to a credit spread (rather than close the trade down). By doing this, you will lock in your current profit; if the underlying goes against you, you will improve your profit. This is one way to avoid a day-trade.

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    1. HI Ron, I don't buy options. I usually ONLY sell premium, or do debit spreads. If I had any idea that I was about to close a tradeI had just opened that day, I would have waited. But I simply forgot (as I do many, many trades per day).

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  4. If you haven't made a habit of breaking the rule, some brokers will allow you to close the restricted account, and then open a new one immediately.

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    1. Apparently Think or Swim is not one of those brokers. I did move my fund to another broker, but then they wouldn't give me the same trading rights that I have
      at TOS. (OptionsXpress won't let me trade at Level 5, so now I can't do naked puts or strangles) Very frustrating.

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  5. Hi Bev, I assume your TOS account is or is about to be unrestricted soon by the posting date. Anyway I just wanted to say if you trigger the PDT rule again it's not that bad for you since you are an overnight holder in general. The PDT rule just makes it so you have to follow the the trade settlement rules. These apply differently for a cash vs margin account. For stocks it's T+3 and for options it's T+1.

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  6. If your account currently states, day trades left =1; how many business day do you need to wait for that to go back to 3(max)? Or this Day trade left:1 will be permanent until the account has $25k balance? never knew about this law....

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    Replies
    1. Please call your broker and get it staight from their mouths. I'm not trading now and I've forgotten more than I remember, so I don't want to mislead you.

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