A common source of frustration for beginner and more experienced traders alike, is the Pattern Day Trader (PDT) Rule. ‘Pattern Day Trader’ is a regulatory designation from the Securities and Exchange Commission (SEC), to discourage retail traders from excessive trading. The PDT Rule places a minimum equity requirement on margin accounts where the stock market trader executes four or more day trades within five business days.
We often get asked many questions about the Pattern Day Trader Rule. And since it can be relatively easy to fall foul of this regulatory requirement (without even meaning to), we think it’s time we give the PDT Rule its own write up. In this article, we define and discuss day trading, the PDT Rule, what happens when you break the PDT rule and ways to navigate around it.
What Is A Day Trade?
Before we delve into PDT, it is essential to understand the meaning of a ‘day trade’.
Now we don’t mean to be trite but a ‘day trade’ is exactly what it sounds like — a trade that is entered and exited on a single calendar day. This includes, pre-market, regular market and after hours trading sessions.
As the term has been accepted into regular vernacular, ‘day trading’ has been wrongly assumed to mean holding a position for a couple of days or holding a position for a short period of time. This is incorrect.
If you hold a position overnight — this is not a day trade.
If you short a stock on Monday and buy to close on Tuesday — this is not a day trade.
A day trade is simply the opening and closing of a position on the same calendar day. In terms of options trading, it is the buying and selling of calls on the same day. For shorts, it is the selling and buying of puts, on the same calendar day.
Given the nature of options trading, traders will often buy multiple contracts of the same underlying stock at the same time. For example a trader may buy 10 option calls on AAPL. Close 5 when stock price hits the traders first profit target and close the remaining contracts throughout the day. This constitutes as one day trade. Not 10 separate day trades. Similarly with vertical spreads, the entire spread is considered a single day trade rather than each separate leg.
Pattern Day Trader Rule
A Pattern Day Trader is a trader who:
- Executes four or more ‘day trades’ within five consecutive business days using the same margin account; and
- The number of day trades makes up more than 6% of the traders total trades for that time frame.
If a trader meets or goes over these ‘day trade’ limits they will be flagged as a Pattern Day Trader by their brokerage. Once a trader has been designated as PDT they will need to comply with the PDT rule.
The Pattern Day Trader Rule places a minimum requirement that the pattern day trader maintains a balance of $25,000 in their margin accounts at all times.
If the margin account falls below the 25K equity requirement, the trader will be prevented from day trading until the account is restored back to the minimum level. Now the 25K doesn’t need to be cash. It can be a mixture of both cash and eligible securities.
The PDT rule is an industry standard and applies to many securities, from stocks, options, bonds, and ETFs. Exceptions to the PDT Rule include Futures, Futures Options and Forex. As these securities are regulated by the National Futures Association (NFA), Futures, Futures Options, and Forex day trades do not count towards your PDT.
Rationale for the PDT Rule
The PDT rule was not meant for the detriment of traders. Rather it was devised as a protection mechanism to prevent retail traders from overtrading and falling into financial ruin. To understand the rationale for the Pattern Day Trader rule we have to look back to the dot com boom of the late 90’s followed by the dramatic bust of 2000. Day trading reached the peak of mainstream popularity during 1999–2000 where making money on the stock market was as simple as buying initial price offerings (IPO’s) on launch day and waiting for the near given 20% increase in stock price. Overvalued IPO’s, retail trading and short squeezes contributed to the NASDAQ Index skyrocketing in early 2000, only to be followed by its sudden collapse of 78% from its highs by mid year. Many retail traders suffered extreme financial losses. Leading the SEC and the Financial Industry Regulatory Authority (FINRA) to implement safeguards to protect retail traders from repeating the same mistakes.
Increased Buying Power
An advantage of being labeled a Pattern Day Trader is that your margin account buying power is increased. Regular non-day traders receive 2:1 leverage capital. For day traders, this is increased to 4:1 where buying power is calculated at the beginning of each day.
This means that a pattern day trader starting the day with a margin account with $25K equity, will be allowed to purchase up to $100K worth of securities for intra-day trades. Non-day traders are only allowed up to $50K.
While using the extra leverage could dramatically increase the potential profits, it also magnifies losses. Traders could potentially lose more funds than they have deposited in their account. And if the difference cant immediately be repaid, the brokerage can liquidate the securities in the account.
Furthermore, individual brokerages may adjust the day trading buying power at their discretion. This will normally be based upon the brokerages risk assessment of the stocks volatility and liquidity. Therefore if you intend on using the extra leverage on opening positions of highly volatile stocks with limited shares, always check with your brokerage first.
Are you a Pattern Day Trader?
- Do you engage in four or more day trades using a margin account in a five rolling business day period?
- Do day trades account for six percent or more of your trading activity during that period?
If you answered ‘yes’ to both — then you are a Pattern Day Trader and you will need to comply with the margin account requirement.
The other way to be designated as a PDT is if your brokerage firm has reasonable grounds to believe you will engage in pattern day trading. For example, if you took a day trading course with your brokerage before opening an account, they may reasonably assume you intend to day trade. Once you have been tagged as a PDT, this designation is usually permanent and you will need to comply with the minimum margin account requirements. However, if you believe you have been wrongly tagged as a PDT you may request for your brokerage to recode you account at their discretion.
Day Trading Rule Under 25K
Where a trader’s margin account has under $25,000 in equity, the PDT rule applies and the trader will be limited to only day trading three times per five consecutive business days,
Day Trading Rule Over 25K
Where a trader’s margin account has over $25,000 in equity, the trader is able to day trade as many times as they choose, as long as their margin account remains over $25,000.
Understanding Your Account Balance
If a trader’s account balance is only a little over $25,000, the trader will need to day trade with caution. There are many factors that can affect account equity and it is essential to understand your account balance before day trading. This is where a lot of traders accidentally fall foul of the PDT rule.
Things that can affect your account balance:
- Unrealised gains or losses — Holding positions with unrealised losses will reduce your trade equity.
- Holding positions that were bought on margin — you will need to subtract the amount of maintenance margin from your trade equity.
- Futures, Futures Options and Forex — Remember these securities are not covered by the PDT rule so funds covering margin on these securities do not count towards the $25,000 account value requirement.
What happens if you break the PDT Rule?
It is far easier to violate the PDT rule than you may think.
Where a trader with $10K in their trading account uses margin to make four day trades in a trading week — they have violated the PDT rule.
Where a pattern day trader lets their trading account drop below $25K on a trading day — they have violated the PDT rule.
So, what now?
The PDT rule is enforced by each individual brokerage. As such, some brokerages may have stricter policies than others. It is always best to confirm PDT policies with your brokerage.
However, if a trader does happen to violate the PDT, the following can be expected to happen:
- The brokerage will issue a margin call — that is a request for the trader to deposit funds into their trading account to restore it back to the minimum level.
- The trader will likely have five business days to answer the margin call. During this time the account will be set to ‘closing only’. This means that new trading positions cannot be opened.
- Failing to meet the margin call will likely result in a 90 day freezing of trading activity on the trader’s margin account. The trader may be restricted to just using their cash account for the 90 days or until they have restored their margin account back to the $25K minimum.
Again, each brokerage is different. Some may be more lenient than others and will issue warnings for first time violations. Others will allow overnight positions to be held. Most won’t allow any new trades at all.
How To Navigate Around the PDT Rule
While the PDT rule was intended as a safeguard to prevent traders from overtrading, it can be a huge source of frustration for many. This is especially true in volatile markets where it can be risky to swing a profitable position overnight instead of taking intraday profits. Below, we discuss the ways to navigate around the PDT rule.
Switch to Cash Account
The Pattern Day Trader Rule only applies to margin accounts, not cash accounts.
Margin accounts essentially allow traders to borrow funds to buy securities — similar to short-term loans. While cash accounts are more akin to regular bank accounts in that no lending is allowed.
A couple things to consider when switching to a cash account:
- You won’t be able to short stocks — Shorting stocks carries immense risk. Regulation T instituted by the Federal Reserve Board requires that traders who short a position, have 150% of the value of that position held in a margin account.
- You won’t be able to trade with unsettled funds — Cash accounts can take a couple of days to settle funds after trading. If you use unsettled funds to open new positions this will likely result in a 90 day lock on your account.
Open Accounts With Multiple Brokerages
The PDT rule is an industry wide standard enforced by each brokerage, not the regulator. Therefore, a work around for the PDT is to trade with multiple brokers. Each brokerage firm will allow for three day trades a week.
An obvious downside is that it spreads funds out thinner, limiting a trader’s buying power in one account. Also, managing different accounts can be quite tedious and traders may incur multiple brokerage fees.
Learn To Trade Futures
As stated above, Futures and Futures Options are not covered by the PDT rule. Futures trading involves speculating on commodity prices and typically requires high amounts of leverage. As such, it is not for the faint of heart. However, for traders that are serious about taking the time to learn and finesse their trading strategies, futures trading can be a worthy and profitable exercise.
Most Importantly — Don’t Over Trade
For traders using margin, try to limit yourself to 2 or 3 day trades a week. Now we understand that this is easier said than done. FOMO is a familiar feeling for most traders. It is tough to sit on your hands especially as the market moves and you are bombarded with promising trade alerts. But restraint is a valuable quality when it comes to trading.
When you focus on finding the perfect trade setup, you may just find that three day trades a week is more than enough. One of the things we stress to all our members is to never blindly follow trade alerts. Practice proper trade management. Take the time to make the trade your own. Find the right entry point, set a stop loss limit, and map out your profit taking levels. Never ever force a trade. Let the trade come to you.