Pattern Day Trading: Chart Patterns and Stocks for Traders

In the dynamic world of financial trading, understanding the intricacies of pattern day trading (PDT) is crucial for any serious trader. This article delves into the definition of a pattern day trader, the key regulatory guidelines, and explores popular chart patterns that can be used by day traders.

What is a Pattern Day Trader?

A pattern day trader (PDT) is a designation given to investors and traders who execute four or more day trades in a single five-business-day period. The term "day trade" specifically refers to the act of buying and selling the same security on the same day. This designation is made by brokers to ensure that traders are aware of and adhere to certain restrictions to prevent excessive trading.

The Regulatory Perspective

The regulation of pattern day traders (PDTs) is overseen by the Financial Industry Regulatory Authority (FINRA). This regulatory body ensures that traders meet certain financial requirements to mitigate the risk of excessive leverage. Notably, pattern day traders are required to maintain at least $25,000 in their margin accounts, which can be a combination of cash and eligible securities. If the account equity drops below this level, the trader is prohibited from making further day trades until the balance is restored.

Chart Patterns to Employ as a Day Trader

Traders looking to capitalize on short-term market movements can benefit from understanding and using various chart patterns. These patterns often occur frequently in the daily trading of stocks and can provide insights into potential opportunities. Here are some common chart patterns:

1. Double Top and Double Bottom

Familiarizing oneself with double tops and bottoms is essential for pattern day traders. A double top is a pattern that appears when a stock has reached its peak and retreats, then tries to exceed that peak again, only to fail and drop back down. In contrast, a double bottom indicates a potential reversal when a stock falls to a low level and then attempts to rise above that low again, but fails to maintain the rally. These patterns form two peaks (for a double top) or lows (for a double bottom), which can signal a potential trend change.

2. Rising and Falling Wedges

A rising wedge is a continuation pattern where the price falls towards a resistance level and then bounces back up, creating a shallower peak. This pattern usually indicates that the stock is likely to continue its upward trend. Conversely, a falling wedge is an inverse pattern where the price rises towards a support level and bounces back down, creating a shallower trough. This often suggests a potential continuation of the downward trend.

3. Fibonacci Retracement

Fibonacci retracement is a popular tool used by traders to identify potential support and resistance levels. This technique involves drawing horizontal lines at key price levels. The most common Fibonacci retracement levels include 23.6%, 38.2%, 50%, 61.8%, and 100%. When a stock retraces a significant portion of its move, these levels can act as potential reversal points. For pattern day traders, recognizing these levels can be crucial in determining entry and exit points.

Examples of Pattern Day Trading

Let's consider the example of Jessica Dunn, a pattern day trader with $30,000 in her margin account. Jessica can potentially carry a position up to $120,000. If her investment in stocks were to grow by 1% on a given day, she could potentially make a profit of $1,200, a 4% gain. This potential for a higher return on investment makes pattern day trading appealing for high net worth individuals, but it also comes with the risk of significant losses.

It's crucial for PDTs to be aware of any margin calls and to maintain the required minimum equity in their accounts. A margin call occurs if the value of the margin account falls below the maintenance margin requirement. In such a situation, the trader has five business days to bring the account back to the minimum equity level. Failure to do so can result in a 90-day cash-only account status or until the issues are resolved.

Conclusion

Pattern day trading offers opportunities for savvy traders who understand the intricacies of market patterns and have the financial resources to manage the associated risks. Familiarizing oneself with chart patterns like the Double Top, Double Bottom, Rising Wedge, and Falling Wedge, and utilizing tools like Fibonacci retracement, can provide valuable insights into market trends and potential trading opportunities.

References

1. Definition of Pattern Day Trader - Investopedia

2. Pattern Day Trader Rule - FINRA

3. Understanding Pattern Day Trading - Nasdaq

Note: Please review these sources for the most current information and regulations.