Pattern Day-Trading Rules: Good intentions, Lousy Consequences

Regulations that restrict opening and closing transactions on the same-day may end soon

News that FINRA is taking the first steps to relax the rules for pattern day-trading sounds almost too good to be true. Easing the burden on retail traders? Mirabile dictu!

FINRA, also known as the Financial Industry Regulatory Authority, is the private industry oversight organization supported by brokerage firms and exchanges.

On the heels of the dot-com bubble back in 2001, FINRA saw the land littered with wannabe traders with blown out accounts. They’d been using leverage to buy hot stocks in quantities bigger than they probably should have been. It worked when those stocks were going up. But as soon as they started to fall, margin calls forced some traders to liquidate and take significant losses.

FINRA decided to help save retail traders from themselves and amended their Rule 4210 to define “pattern day-trading” and create margin rules that would severely restrict same-day opening and closing transactions in stocks, exchange-traded funds (ETFs), stock and ETF options, and equity index options. 

Because FINRA lives on the equity side of the financial world, futures and futures options were left alone.

Very simply, the pattern day-trading rule said that if a trader’s account has less than $25,000 net liquidating value, he can’t do more than three day-trades in five business days. The devil is in the details of rule 4210 and the idea was that smaller accounts couldn’t use leverage to day-trade (e.g. buy 100 shares of IBM with leverage on Tuesday morning, and sell 100 shares of IBM on Tuesday afternoon). If the trader did four or more day trades in five days, the account would be restricted to cash-only trading for 90 days.

On its face, the pattern day-trading rule sort of makes sense. The bigger the bet, the bigger the potential loss. And retail traders with smaller accounts may not have the financial cushion against those losses.

But 2001 was also the dawn of the revolution in retail options trading. Traders were learning how to use option strategies like verticals, iron condors, strangles and butterflies. And according to FINRA, each leg of those strategies was a trade. So, an iron condor was four trades for pattern day-trading purposes. But iron condors could have low capital requirements, which could make them suitable for smaller accounts less than $25K.

Take the case of a new trader who doesn’t know pattern day-trading rules but wants to get started in options. He might sell an iron condor in the morning and buy it back in the afternoon, either for a small profit or simply because he doesn’t want to hold the position any longer. That’s four day trades. If that trader didn’t have an account worth $25K, he’s basically shut down from trading any more option spreads for 90 days. That’s not saving the trader from himself. 

That’s squashing him just as he’s getting started, and it’s the lousy consequence of the pattern day-trading rules.

As you can see, it’s not hard for someone trading options with a sub-$25K account to find himself with that problem, particularly if he’s trading 0 DTE index options, which are the new hotness.

But whether you trade options or stocks, here are four reasons that pattern day-trading hurts investors who try to make sensible decisions.

1) They keep people from taking profits or limited losses when they want to. Stock prices can change dramatically throughout the day, and may present opportunities to close a position established earlier in the day at a profit. Boom. Day trade.

2) They discourage people from using defined-risk options strategies. A vertical trade can have less risk than simply buying or shorting the underlying stock. But the two legs that give it defined-risk create two day trades if the trader closes it on the same day. Do that twice in five days, and your account can be restricted.

3) They push people to carry risk longer than they want to. To avoid the dreaded pattern day-trading restriction, a trader might hold a multi-legged option spread, or even shares of stock, overnight instead of closing it on the same day. That increases, not reduces, risk.

4) They don’t protect investors from their own bad behavior. You can lose the entire value of your account value in one day by taking too much risk and without day trading.

Reducing the account value from $25K to $2K before pattern day-trading status kicks in would be a huge improvement for retail traders. Eliminating it entirely for a risk-based approach instead of a transaction-based approach would be better, but it’s a step in the right direction. Let’s hope the plan becomes reality.

Tom Preston, tastylive chief market strategist, is responsible for the brokerage’s trading strategy, client-facing trading software and futures trading products. He contributes to Luckbox magazine and writes tastylive's Cherry Bomb newsletter. He's been trading options since 1992.

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