I disagreed with a change made a decade or so ago to save day traders from themselves. That change required that those traders identified as Pattern Day Traders maintain at least $25,000 in equity in their accounts. Since then, traders with less than that amount have been restricted to three round-trip options trades a week.
In the Winter 2012 issue of thinkMoney, Adam Warner defines Pattern Day Traders as those who "make four or more round-trip day trades within any rolling 5-business day period," with those trades representing "at least 6 percent of your total trading activity during the same period" (34). The ruling probably resulted from a reality of trading small accounts that inexperienced options traders might not understand.
Risk-of-ruin studies show that the risk of running through one's account rises with smaller accounts. I've read anecdotal evidence that corroborates the conclusion that the smaller the account, the more likely the trader is to run through the funds. It's just logical, and you don't need sophisticated statistical calculations to come to that conclusion. The proportionate size of trades rises when compared to the size of the small account. I've always counseled against devoting too large a percentage of your trading capital to any one trade, mentioning how that increases the risk that traders will run through their accounts. So why do I seem to be prevaricating here, saying I have a quarrel with the ruling?
I object for several reasons. First, as foolish as we traders can be, it's our money. If we want to ignore all advice and run through it, then so be it. In fact, before this ruling was made, I sometimes set up micro accounts to test a certain trading strategy. I was often pretty sure that I was going to run through the account while I was testing and refining the new strategy. That's what happens before you refine a strategy: you pay a tuition by losing money. However, the purpose of setting up the micro account was to ease from simulated or paper money trades on the strategy to live trades without putting the bigger account at risk. I wanted the money I was willing to devote to a new strategy at risk and not a cent more.
I've known inexperienced traders who hit a losing streak, then plowed more and more capital into the trade. It's easy to do with an iron condor that's going wrong, Martingaling the trade by rolling out into more contracts to make up for the debit you paid to roll. A Martigale system is, according to Investopedia, one "in which the dollar values of investments continually increase after losses," but it's more. It's also when the "position size increases with lowering portfolio size." In other words, if I have 10 call credit spreads that need to be moved, but I want to pay for the debit I will incur by rolling into 20 call credit spreads at a higher strike, I'm engaging in a Martingale system. That kind of system can work if you're trading small and have deep pockets. It's an adjustment I've used in the past but would use with extreme caution. Eventually, you're going to run out of money and that "eventually" isn't very far off when your account is small. That eventuality is far better than the case of the inexperienced trader with lots of money to throw at a trade, however, and with the propensity to Martingale the trade many times or double down on a losing trade. Having more capital available, especially when it's your 401K, your widowed mother's life savings, or other essential capital, doesn't guarantee that you're a more knowledgeable or trustworthy trader. It doesn't protect you.
However, my objection arises for a different reason, and it's an extra risk those considering day trading in a small account must acknowledge as long as that Pattern Day Trader rule remains in effect. I was still day trading when that ruling first came out. Moreover, I had scaled back my trading, limiting myself to accounts with a few thousand. The market environment had changed, and a family member's health was changing my personal trading environment, also, so I needed to change the way I traded. I didn't know exactly which strategy changes would work best for me, and I was experienced enough to know that I didn't want to risk losing a lot of money to find out. At the time, I was testing a strategy that blended observations about the advance/decline line with observations about price action, if I'm remembering correctly. That was a strategy that required me to react quickly, jumping in and out of trades quickly when the adv/dec line changed. In that market environment, the strategy had a strong win rate, but gains might be small.
The change in the ruling hamstrung me while I traded that account. I couldn't jump in and out quickly, at least not more than three times in one week. What happened? I started switching from taking quick profits in trades that lasted minutes to staying in the trade longer. For example, if I had a small loss when a reversal began but I had reason to believe the reversal would be a small and temporary one, I might not jump out of the trade and wait for the next setup. I didn't want to lock in a small loss and use one of my three round-trip trades if I thought the trade was eventually going to go my way. I wanted to be able to capture the gain I still thought might be possible.
I wasn't the only person changing the way I traded as a result of the ruling. Others were staying in trades they thought might eventually work rather than jumping out of them, as they might have done in the past, and waiting for the next setup. I heard from many other traders changing their trading in a simular way. Particularly in the beginning but often throughout their trading lives, many active traders trade accounts smaller than $25,000. The Pattern Day Trading Rule hamstrings some income traders, too, who put on a monthly trade but are active about hedging their risk, say with extra longs or debit spreads that they remove when the risk is gone.
You can guess the ending of that story about that test I was running at the time, right? My stellar win/loss rate became not so stellar. Some of those temporary or small reversals turned out not to be so temporary or remain as small as the smaller losses I would have locked in if I'd still been able to hop in and out of trades at will. The whole thing fell apart. I had allotted a certain amount of money in which to test that trade, and the test resulted in my spending that tuition to learn that, unless I wanted to trade this trade in the larger accounts when I could still jump in and out, it wasn't going to work.
That temptation to stay in a trade when a reversal might be small or temporary is too hard for many traders of small accounts to resist. The dread of using up the available three trades on two or three small losses only to miss the big win might sway traders to stay in a losing trade too long. If you're going to day trade a small account, understand this temptation and the way it can impact your trading decisions. Either plan to use up the entire account as a tuition fee or take other steps to limit the damage when you can't jump in and out at will. Consider investigating a way to automate your exit orders, removing that temptation. Investigate other types of trades that are still small and with defined risk, but which may develop over a period of days or weeks rather than minutes. I have a teensy account that I use to test debit spreads on stocks that I think might be headed a certain direction over the next week or two weeks, for example. Verdict's still out on that one, with me mostly churning the money around and making my broker happier than I'm making myself, at least so far.
Find something that works for you, but be aware of the pros and cons of day trading in an account in which you're limited in this manner.