My petition to the SEC

I feel like I'm on a one-man crusade against the pattern day trader rule.

I've written the SEC and FINRA in the past about this, but not through formal channels. Today I discovered the SEC's petition site. In fact, you can read one person's letter about the pattern day trader rule here.

After discovering this, I decided to write my own formal petition which I will be mailing to the SEC. Sure, it may not do a damn bit of good, but this rule is so utterly absurd that I just can't shut my mouth about it.

Here's my letter:

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Nancy M. Morris
Secretary
Securities and Exchange Commission
100 F. Street NE
Washington, D.C. 20549-1090

Dear Ms. Morris:

I am writing to propose an amendment to, or repeal of, NASD rule 2520, also known as the Pattern Day Trader Rule. This rule, established in 2001, was designed to mitigate the risks of day trading among individuals with small accounts. Certainly, day trading is associated with significant risk, and many traders have lost large amounts of money. While the pattern day trader rule was designed to mitigate this risk, in some ways it actually increases it.

One of the most important aspects of trading is to protect capital at all times. This means taking losses quickly and minimizing losses as much as possible. However, the day trading rule encourages small account traders to hold losing positions, as some traders may not want to use up their limited day trades. Also, if one is out of the 3 allowed day trades per week, the trader then cannot exit a position quickly if necessary without violating the rule and risking account restriction. Thus, the pattern day trader rule penalizes small account traders for protecting their capital.

For example, my largest trading loss was a direct result of this rule. I had intended to enter an overnight position in a trade, only to see the price fall rapidly after-hours. Yet, I could not exit my position without violating the rule (as I had already used up my 3 day trade allotment). In fact, my broker’s software rejected sell orders for individuals who were out of day trades. I eventually had to contact my broker to force the trade through. I suffered an enormous loss because I could not exit the trade quickly. My account was also restricted. Thus, I was penalized for trying to protect my capital.

One can also imagine a situation where a non-pattern investor, on a particular day, diversifies among a number of stocks and then sets stops on them to protect from large losses. It is very possible that 4 or more of those stops could get triggered on the same day if the overall market behaves unexpectedly. Thus, the investor’s account is restricted despite the fact he is not a day trader. Again, he is penalized for protecting his capital.

The pattern day trader rule encourages people to hold overnight positions. However, one could argue that overnight positions are inherently more risky than day trades, as stocks can gap up or down significantly overnight. At least with a day trade, one can watch the price action and exit if necessary.

Another problem with this rule is that it encourages beginning traders to commit more money to trading when first starting out than they should. It is better for a trader to learn with a small $10,000 account, then to try to learn with a $25,000 account; the trader loses less money if he is not successful. A trader frustrated by the pattern day trader rule may commit more money to trading than he should, taking money from savings accounts or other sources that normally he would not be risking.

The rule also has an adverse effect on the small account trader. Because the trader is only allowed 3 trades per week, it puts pressure on him to make the “perfect trade” in an effort to try to conserve day trades. This can adversely affect trading strategies, for it can cause traders to hold onto losing positions, or to take profits too quickly. It also penalizes a trader for making mistakes; if a trader gets into a trade and then realizes he has made a mistake, he may exit, but have to use up a day trade in the process. The rule does not allow a trader to effectively learn. It hampers progress.

There is also the psychological phenomena of “wanting what you can’t have.” Thus, it may actually create conditions where traders become more obsessed with trading than they should. I know, in my own past experience, this rule had made me want to trade more often, simply because I felt overly restricted from trading…like my “hands were tied.”

Also, one might argue that the pattern day trader rule represents government “paternalism” and an inappropriate limitation on personal freedom. If a trader is allowed to buy a stock on one day and sell it the next month or the next day, then there is no logical reason that he should not be allowed to sell it the next hour or the next minute. No such rule exists in other countries, such as Australia, Canada, or European countries.

Finally, the day trader rule does not make any sense. First, the rule implies that a trader with three separate $10,000 accounts is somehow less sophisticated or able to effectively trade than one with a single $30,000 account. It further does not make sense to restrict day trading stocks, yet put no restrictions on day trading futures or currencies (which are inherently more risky than day trading stocks). Finally, since one could easily lose massive amounts of money on a single overnight trade or long-term position trade, it does not make sense to restrict day trading when any type of trading has the same inherent risk.

In summary, the rule is overly restrictive, and, as I mentioned before, can increase risk rather than decrease it. The rule punishes traders for protecting capital.

A true day trader often makes dozens of trades per day. Thus, it does not make sense to label someone as a “pattern day trader” if one does 4 day trades in a rolling 5 business days. I propose that either the SEC repeals the rule, or increases the number of allowed day trades to a more reasonable number. For example, 10 day trades every 5 business days (or 2 per business day) is a much more reasonable number. It would give small account traders and investors more flexibility, while still limiting excessive trading. However, my personal feeling is that there should be no limitation on the number of day trades; instead, there should be limitations on the use of leverage for people with small accounts. This would be much more effective at preventing small account traders from losing excessive amounts of capital.

Sincerely,

James Krieger, M.S.

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