Margin Requirements for Pattern Day Traders

Day trading is characterized by buying a security then selling it within the same trading day. Those who frequently engage in day trading are known as pattern day traders. Specifically, you are a pattern day trader if:

• you execute day trades at least 4 times in a 5-day period (counting only business days), and
• 6 percent or more of your trading activity in that same 5-day period are day trades.

Only if you fulfill both conditions can you be considered as a pattern day trader. Let's say, for instance, that in one week, you executed the following trades:

• Monday: you bought then sold Security A, Security B and Security C
• Wednesday: you bought then sold Security D
• Thursday: you bought then Sold Security E and Security F.

In this example, you have executed day trades 6 times in a 5-day period. This does not automatically make you a pattern day trader. However, if these day trades constitute 6% or more of your trading activity for that week, you are classified as a pattern day trader.

Day Trading on Margin

Some investors buy securities using so-called margin accounts. Margin accounts make it possible for some investors to buy more securities than what the assets they have in their accounts would permit. The extra fund comes as a loan from their broker.

Margin accounts are a great tool for day traders. Day traders, after all, typically rely on volume trading to make a profit. Volume trading requires enormous amounts of capital, and margin accounts make just such a capital available when needed.

Borrowing money from your broker costs money in interest, of course. This doesn't faze day traders, however.

Brokers charge interest rates on margin account balances left overnight. Day traders, on the other hand, always close their position before trading day ends. With a little luck, they could return the money they borrowed before the end of the trading day. In effect, they'd be turning in a profit using money they loaned at zero interest.

Pattern Day Traders: Important Margin Rules

By their very nature, margin accounts may be abused by investors. Some investors could borrow a lot of money then lose all of it (and then some). They would be unable to return the money he borrowed from his broker.

Day traders pose even more of a risk. Day traders are very active traders. The great volume of securities they buy and sell in any given day could bring them huge profits - or huge losses. Day trading on margin therefore poses an even more serious threat to market liquidity.

Therefore, there are rules that pattern day traders need to abide by when day trading on margin. The following are some of these limitations:

• Minimum equity requirement of $25,000

  A pattern day trader buying on margin must have a minimum equity of $25,000 in his margin account before he can execute a day trade. Day trading would be off limits to a pattern day trader whenever he falls below this minimum margin requirement.

• Buying power restriction

  On any given trading day, a pattern day trader can buy only up to 4 times the value of his margin excess by the close of the previous trading day.

  This is just another expression of the maintenance margin requirement (see below) except that this rule specifically applies to pattern day traders. This is simply saying that pattern day traders have a minimum margin requirement of 25%. This margin requirement, however, is often greater since brokerage firms usually set a higher margin requirement.

• 2-business day rule

  If a pattern day trader deposits funds/securities into his margin account to meet the required minimum equity or margin, these additional funds/securities must remain in his account for at least the 2 business days following his deposit.

  The following are additional restrictions that also apply to pattern day traders who trade on margin. These limitations apply to all margin accounts.

• Maintenance margin requirement

  Margin accounts have a maintenance margin requirement. The margin is the ratio of your Net Equity to your Total Equity. There's a required minimum margin ratio if you owe your broker money.

  The maintenance margin ratio requirement varies per brokerage firm. The minimum maintenance margin requirement set by National Association of Securities Dealers as well as the New York Stock Exchange is 25%. Brokerage firms often have higher maintenance margin requirements.

• Initial margin requirement

  This is the amount of debt-free, unmargined equity that a margin trader has to have in a margin account before he can purchase securities or open a position on margin.

  The initial margin requirement is often higher than the maintenance margin requirement. Once a position has been opened, the maintenance margin requirement applies. Anything in excess of the maintenance margin requirement becomes margin excess.

• Margin excess requirement

  Only assets in excess of the maintenance margin requirement (such excess is also known as unmargined securities) may be withdrawn or used to purchase more assets.

  Let's say, for instance, that your total equity is $60,000 and you owe your broker $30,000. In this case, your Net Equity is $30,000 so you have a margin of 50%. If your brokerage firm requires only a 30% margin, then your Net Equity requirement is only $18,000. Therefore, you have $12,000 in unmargined equities that you can use to purchase more securities.

• The margin call

  The margin call is made whenever the ratio of the net equity to the total equity falls below the maintenance margin requirement. Whenever a margin call is made, the margin account owner must immediately deposit more funds into his account or liquidate assets until his margin once again matches or goes above the minimum margin requirement.

  Let's say that you purchased 1,000 shares of Company A at $60. You used $25,000 of your own equity and borrowed the rest (or $35,000) from your broker. Your broker's maintenance margin requirement is 40%. This purchase, on the other hand, has given you a margin of:

  Total Equity = 1,000 shares x $60 = $60,000
  Net Equity = Total Equity - Borrowed Money = $60,000 - $35,000 = $25,000
  Margin = Net Equity ÷ Total Equity = $25,000 ÷ $60,000 = 41.67%

  Just for the sake of illustrating a point, let's suppose that in the course of the trading day Company A's share prices suddenly declined to $50. Consequentially, your total equity was drastically reduced to $50,000, and this negatively affected your margin. To illustrate:

  Total Equity = 1,000 x $50 = $50,000
  Net Equity = Total Equity - Borrowed Money = $50,000 - $35,000 = $15,000
  Margin = Net Equity ÷ Total Equity = $15,000 ÷ $50,000 = 30%

  At this point, you would be served with a margin call since your new margin of 30% is lower than your brokerage firm's minimum margin requirement of 40%.

  To satisfy this margin call, you'd have to increase your Net Equity from $15,000 to at least $20,000. You could do this by channeling more funds into your account. You could also sell some of your securities to reduce your debt burden.

When a Margin Call is Made on a Pattern Day Trader

A pattern day trader is issued a margin call:

• when his margin falls below the required minimum
• when he goes over his day trading purchase limitations

When a margin call is issued a pattern day trader for exceeding his buying limitations, he is given 5 business days or less to satisfy the margin call. Note that cross-guarantees may not be used to satisfy the maintenance margin requirements for day trading.

In the 5-day (or shorter) grace period, a pattern day trader's purchase limits are reduced to 2 times his margin excess. If the margin call remains unsatisfied after the grace period has lapsed, his trading powers would become even more restricted. For 90 days or until he makes good on the margin call, he'd have to use cash to buy securities.

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