Have you ever heard of the term “Pattern Day Trader?” This special Security Exchange Commission designation is used to identify traders who buy and sell the same asset more than four times a day. Trading must make up at least six percent of all of their activity during this period and such trading must occur for at least five days in a row.
A pattern day trader must maintain $25,000 dollars worth of equity in their account. If a pattern day trader does not maintain the necessary $25,000 dollars in equity, they may be banned from conducting further trading until they meet the necessary requirements. The SEC has instituted these rules to make sure that traders have the money on hand to cover any losses they might incur.
Why the SEC Monitors Pattern Day Traders
So why does the SEC bother with the special designation for a pattern day trader? The SEC’s primary job is to protect the financial markets of the United States. In order to protect markets, the SEC monitors some high risk traders, including pattern day traders.
Day trading is considered a high risk trading method. While day trading can result in substantial profits, it can also generate big losses. Thus, ensuring that traders can cover their losses is essential for ensuring stability in markets. Also, day traders often close their position at the end of any given trading day. This might seem like a minor point, but reporting restrictions are more lax for traders who close out their position. Creating other monitoring mechanisms can thus provide extra assurance.
So What Makes Day Trading So Dangerous?
Day traders often trade in highly speculative assets, such as penny stocks. Price volatility is essential for day traders because that is how they make their money. Day traders need prices to rise and fall substantially within a given day to generate substantial profits. Yet if traders bet wrong, and markets go in the opposite direction that they expect, losses can add up very quickly.
Another important thing to consider is how much leverage any trader is trading with. Leverage refers to money loaned to a trader by a financial institution so that they can buy and sell more assets than they could solely with their own money. Leverage greatly increases the potential to produce profits, but it also increases the risks of suffering massive losses. Further, it’s possible for traders trading with high levels of leverage to actually incur losses that outweigh the amount of money in their trading account.
Before, only major financial firms were conducting day trading. These firms generally have the money to cover any losses. Twenty years ago it would have been very difficult for small traders to conduct trading. This is because trading was conducted more slowly and had to be arranged through a brokerage firm. Since day trading requires rapid reactions to volatile movements in markets, it simply wasn’t possible for anyone who didn’t have quick and immediate access to an actual trading floor or market.
With the advent and proliferation of electronic trading, however, just about anyone can establish a trading account and conduct day trading. Yet smaller traders may not understand or fully account for the high levels of risks involved with day trading. Given this, the risk of people conducting day trading, suffering losses, and then being forced to default on their debts increases. This is one of the reasons why the government has upped its oversight over day traders.
Giving out the designation for pattern day traders, and installing special requirements thus helps ensure that traders will be able to absorb losses. This helps give the government a certain level of oversight and assurance against day trading activities. This in turn increases market stability.