Pattern Day Trader - Rationale

Rationale

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 rule essentially works as a stop-loss on an unsophisticated traders account, disabling the traders ability to continue to engage in high-risk 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.