The Pattern Day Trading rule was implemented back in 2001 as a safety feature to help reduce the risk associated with day trading as the previous rules were deemed insufficient.
Day trading became what some would call “mainstream” in the later part of the 1990s and was popular by 1999-2000. The heavy base of technology in the Nasdaq Index skyrocketed through 5,000 by March 2000 fueled by day traders, overvalued initial public offerings (IPOs) and short squeezes. The NASDAQ price/earnings (P/E) ratio grew to 200. Ultimately, the bubble burst in mid-2000, as the Nasdaq collapsed 78% from its highs. Retail traders with hopes and aspirations of quitting their day jobs to become full-time traders fell back to earth when the bubble popped.
The extreme losses suffered by retail day traders prompted the Securities and Exchange Commission (SEC) to implement new rules in an attempt to “protect” unsophisticated retail traders from repeating the same mistakes. The SEC collaborated with the NYSE and NASD to determine a “Pattern Day Trader”, as one who executes four or more round trips in a rolling 5-business day period in a margin account.
The SEC implemented the mandatory $25,000 minimum account equity requirement for accounts that qualified as “Pattern Day Trader” under NASD Rule 2520 and NYSE Rule 431. The PDT Rule attempts to protect small account retail traders. capital (under $25,000) by limiting the trading activity. The assumption is that retail customers with over $25,000 in account equity are assumed to be familiar with the accepted the risks entailed with day trading.
While establishing a minimum watermark, they also increased the buying power for margin accounts above the $25,000 watermark from 2 to 1 up to 4-to-1 margin or 25% margin requirement. Therefore, a margin account with $25,000 cash allowed for up to $100,000 for intra-day buying power and 2 to 1 on overnight positions, or $50,000 in this example.