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Rule 2520 Explained
by Witold
Chrabaszcz
On February 27, 2001, the SEC approved rule changes proposed by both the NYSE and NASD
Regulation, Inc. aimed at imposing more stringent margin requirements for day trading
customers. The effective date for the implementation of the New York Stock Exchange's rule
was August 27, 2001. The NASD's rule went into full effect on September 28, 2001.
Prior to September 28, 2001, firms were able to impose more stringent rules on day traders
at their own discretion. In my experience, very few actually did.
The new rule caused much confusion among investors even before it was
passed. Unsurprisingly, SEC managed to add to this unease by being particularly vague and
unwilling to communicate more clearly new rule provisions to an average investor.
Reading the two rules, however, is not as painful as I thought it would be.
In a nutshell, NASD Rule 2520 (and identical NYSE Rule 431) impose an additional suitability
obligation on online broker-dealers that permit day trading. From now on, accounts that
meet pattern day trading criteria and do not meet the new equity requirements will not be
allowed to day trade, period. Executing day trades in violation of rule 2520 is likely to
result in the removal of margin approval, account citation for trading violations, and/or
full and immediate lockup of the account.
The rule itself is pretty simple. A day trade is defined as buying and selling the same
security on the same day. To qualify as a pattern day trader, however, one must make at
least four such trades in a five business day span AND these intra-day trades have to
constitute more than 6% of a trader’s total trades for that five day span. In other words,
if a trader makes 100 trades in a given week, and five of those are day trades, then he does
not fall under Rule 2520. However, if seven of his 100 trades are day trades, he meets both
criteria outlined above and has to maintain an equity requirement of at least $25,000.
In exchange for this high-equity maintenance requirement, Rule 2520 will permit a trading
margin up to 25%, allowing a day trader to leverage his $25,000 account equity to buy/sell
up to $100,000 in equities. This may be a blessing in disguise for individuals willing to
take on the risk. Old margin ratio was a (comparatively) measly 50%.
One group that will likely feel the pinch of this rule are the ultra low cost brokers that
built their name by selling the “E-trade dream.” Right now, one can day trade at Datek with
as little as $500, for example, and there’s a whole legion of discount brokers that are
offering ever lower account minimums. (or no minimums at all.) Suddenly, these brokers are
forced to enforce a rule that will have a big impact on their target customer. Their
customers will end up making fewer trades, some will leave, and some will never open an
account. Each of these scenarios hurts the broker’s bottom line.
Moreover, even though the two rules are not clear as to whether or not the new equity
requirement applies to cash accounts, it is perfectly obvious where things are heading. In
addressing this question, SEC’s response is quite clear: “Although it doesn't expressly
address the issue, Regulation T (a rule issued by the Federal Reserve Board that governs the
extension of credit by brokerage firms) does not permit day trading in a cash account. You
will find an explanation in a Federal Reserve Board staff letter dated February 18, 1999. “
(staff
letter)
In the end, the rule is a mixed blessing for investors. Those who meet the $25,000
requirement will have additional margin flexibility. Those that don’t will face substantial
limits on their trading strategy. Brokers will be affected depending on the extent to which
they serve small speculators: the higher the number of small day trading accounts, the more
negative the impact on the bottom line.
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