The world of day trading attracts everyone from far and wide. The US stock market is the most liquid in the world and draws in a lot of American traders.
If you fit the description above and are a new trader looking to start day trading stocks. We’ve got some advice for you!
Do you have less than $25,000 of capital to start trading with?
If you’re in this boat, the Pattern Day Trader (PDT) rule will likely affect you so make sure to follow along closely!
In this post, we walk you through what the Pattern Day Trader rule is, how it affects you and how you can avoid it altogether!
Pattern Day Trader Rule: What is It?
The Pattern Day Trading rule was implemented back in September 2001 by the SEC and FINRA. It is in effect in the US.
The purpose behind the rule is to protect brokerage firms and retail traders from margin calls and excessive losses as a result of day trading activities.
So how does it actually work?
Well, in order to understand the PDT rule, we must first define some terms related to brokers and brokerage accounts:
Settlement Period – When you make a trade it can take up to 2 days for the funds to settle. During this time, your funds are not available to trade.
Cash Account – a type of account that is subject to settlement period restrictions. This means that you will need to wait for funds to fully settle in order to continue trading. You are not able to day trade in cash accounts. Since failing to pay for a security before you sell the security violates the free-riding prohibition. If you free-ride, your broker must place a 90-day freeze on your account.
Margin Account – the type of account for day traders! The broker provides the credit so you don’t have to wait for funds to settle. You are also able to short sell stocks and trade more complex options strategies with this account type.
Most day traders will open up a margin account with their brokers in order to buy and short sell stocks intraday and access leverage! Now that you’re familiar with these terms, let’s move on!
The PDT rule applies to all margin accounts and comes into play when you execute four or more “day trades” within a rolling 5 business day period. This applies to short sales, as well as options positions. If you have an account that is below $25,000!
The other criteria for the PDT rule is that “day trades” must represent more than 6 percent of the total trades in the margin account for that same 5 business day period.
This is a minimum requirement and some broker-dealers may use a slightly broader definition in determining whether a customer qualifies as a “pattern day trader”.
What is a “day trade”?
The FINRA considers a day trade to be buying then selling or short selling then buying the same security on the same day.
Purchasing or short selling a security without exiting the position later that same day will not be considered a day trade.
So if you buy a stock, hold it overnight and then sell it the next morning on the open, the trade would not fall under the PDT trade.
Let’s look at some examples to clear this up:
If you buy 300 shares of FB and then sell those 300 shares of FB on the same day, that is considered a day trade. If you do this another 3 times within 5 business days, FINRA considers you as a pattern day trader.
Now let’s say you buy 300 shares of AAPL today and sell them tomorrow morning on the open. This is not considered to be a “day trade” by the FINRA definition.
So What Does It Mean to Be A Pattern Day Trader?
Once you trigger the pattern day trader rule, FINRA requires the broker-dealer to impose special margin requirements on your trading account.
Under the rules, a pattern day trader must maintain minimum equity of $25,000 for any day that they wish to day trade. In addition to this, the required minimum must be in the account prior to any day trading activities and must be maintained throughout the day. If the account falls below the $25,000 requirement during the session, the trader will not be permitted to day trade until the account is restored to the $25,000 minimum equity level.
Triggering the PDT rule on your trading account can greatly affect your trading activity! Especially if have less than $25,000 of capital to start with!
We’ll provide some options to avoid the PDT rule shortly, but let’s quickly look at one of the benefits of being considered a pattern day trader.
The Plus Side to the PDT Rule
The plus side to being a pattern day trader is that you will have more buying power available to you than a non-daytrader! You will get 4:1 day trading buying power versus the standard 2:1 buying power.
So what does this mean?
Well, if you have $30K in your trading account, you will have $120K in buying power to day trade with compared to the $60K buying power for standard margin account holders.
The added leverage can provide for a higher return on investment, however, the potential for significant losses also becomes greater!
If there is a margin call on the account, the pattern day trader will have 5 business days to answer it. During this time, buying power goes down to 2:1 until the margin call has been met. If the margin call is not met by the fifth business day, the account is restricted to trading on a cash available basis for 90 days or until the call is met!
What Happens If You Violate the PDT Rule?
If you violate the PDT by making more than four day trades in a 5-day period when you have less than $25K in account value, your broker will give you a warning on your first offense.
If this happens again, then your account will be frozen for a minimum of 90 days or until you add money and get the account value back over $25K.
You can see the obvious limitations this may provide to someone with a smaller account looking to start day trading. If this is you, fear not! We’re about to dive into some of your options to get around the PDT rule!
Pattern Day Trader Rule: How to Avoid It!
Try A Longer-Term Strategy
One of the ways to get around the PDT rule is to adapt your strategy outside the bounds of day trading!
You can try your hand at swing trading and build your account up by taking this approach.
You would be holding positions for longer than one trading day, sometimes for several days or even weeks.
Once you grow your account balance over $25K then you could look to transition into the day trading arena.
Open Several Different Margin Accounts
Let’s say you have $10k of trading capital to start with and you want to day trade.
What you can do is open several accounts and partition the cash between them.
So you open up 4 different margin accounts and deposit $2500 into each of them.
Now you’ll have 16-day trades that you can make in a 5 day business period instead of being limited to only 4.
This option can get expensive, confusing to keep track of and we don’t really recommend it. However, if you are desperate to day trade stocks, it might be a viable option!
Since the CFTC governs futures trading, futures are exempt from the pattern day trader rule.
Day trading futures contracts offer you greater leverage than day trading stocks on margin.
In addition to this, the commissions for futures are generally more favorable for active traders.
Profits from trading futures are also taxed more beneficially than profits made trading stocks.
This makes futures day trading extremely attractive over day trading stocks.
Since the forex markets are not governed by the SEC or FINRA, the pattern day trader rule does not apply in this arena.
Similar to futures trading, forex offers higher leverage than stock trading and preferred tax treatment for profits.
If your trading strategy revolves around stocks, unfortunately, this option would not work best for you!
The Bottom Line
The pattern day trader rule can be confusing for many new day traders!
Whether you like it or not, it will affect you if you plan on day trading stocks with less than $25k capital.
Now that you are familiar with the PDT rules you are well prepared to start your day trading journey.
If you have less than $25k and wish to start day trading, we recommend taking a look into day trading futures to overcome the PDT rule!
Futures are our favorite asset to day trade and you can start with as little as $3000-$5000!! There has never been a better time to start.
The most important thing that you can do now to cut down your learning curve is to find a mentor and join a community of professional traders.
If you want to join us in our live day trading room and trade alongside a community of professionals, check out our ELITE package here
Prefer to trade more passively? Check out our newsletter, trade ideas and live analysis in the Swing Trader package here.
The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.