Thanks to technological advances, actively trading stocks is now easier than ever.
Most brokerage firms allow day traders to trade stocks via internet, telephone and even on your smartphone.
However, while the process of buying and selling stocks is easy, you may still be locked out of trading or miss a wonderful opportunity because of day trading restrictions.
Pattern Day Trading (PDT) restriction
The pattern day trader (PDT) rule is a restriction set by the U.S. SEC and FINRA to limit the number of trades that can be executed in accounts with small amounts of capital. Including margin accounts with less than $25,000 net liquidation value.
The PDT rule was created shortly after the dotcom bubble of the late 90s and early 2000s. The PDT rule effectively holds pattern day traders using margin accounts to higher standards than individuals trading with cash accounts. They do this by requiring them to maintain larger amounts of cash and/or securities in their accounts.
The two U.S. stock market regulators, designed this rule as safety feature to help minimize the risks associated with day trading.
How the pattern day trader rule works
A day trade is when you buy or short a stock or another financial instrument and then sell or cover the same stock in the same day. People who indulge in this form of speculation are known as day traders. Here is how the pattern day trader rule works:
If you make four or more day trades in your brokerage account in any rolling five-day period, and those trades account for more than 6% of your account activity over the period, your broker will flag your account as a pattern day trader account.
When this happens, even by mistake, you will have to keep a minimum balance of $25,000 in the flagged account on a permanent basis.
Less Than $25k
If the account has less than the $25,000 at the close, you will be limited on the next day to making liquidating trades only. Essentially, if you have $5,000 in a margin account, you can only execute three days over the course of any five business days.
Not every day trader wants to keep $25,000 in their trading account. Therefore, make sure to pay close attention to your trades to prevent your account from getting flagged.
In most cases, however, you usually do not have to worry about breaking the PDT rule by mistake because your brokerage will notify you. If you don’t heed to your brokers warning, they will freeze your account for a period of 90 days.
More Than $25k
An account may still be identified as a pattern day trader even if it has a balance of $25,000 or more. In such a case, you can still continue to day trade as long as you don’t not exceed the day trading buying power of the account.
That said, some brokers do allow a one-time exception to clients who have been flagged as day traders. As long as they promise not to use the account for pattern day trading going forward.
Margin restriction
A margin account is a brokerage account that allows you to buy stock by borrowing money. This type of account is different from a cash account. A cash account requires the client to pay in full for the stocks or securities they want to buy.
To open a margin account, you have to go through an application process that has to be approved by the broker..
For a margin account, a $2,000 minimum is required but you will be given 2:1 leverage. This means that if you have $2,000 in the account you will have a buying power of up to $4,000.
When trading on a margin account, you will be subject to the PDT rule. This requires you to maintain a minimum of $25,000 in equity in the account if you make 4 day trades or more in a 5 day period.
If your account is a pattern day trader, you will not be able to day trade until you maintain that account minimum. Nonetheless, if you do have the minimum equity requirement, you may have up to 4X day trade buying power.
So if you had $25,000 in your account then you could use up to $100,000 to day trade. If you exceed this amount, margin calls could further limit your trading frequency and buying power. It is also important to point out that you cannot use your day trading buying power to hold positions overnight.
Short-selling restriction (SSR)/ Alternate uptick rule
Another common hurdle that day traders frequently have to deal with is the short-selling restriction (SSR), a rule that came out in 2010 in the wake of the 2008 global financial crisis. The rule, also known as the alternate uptick rule, restricts the ability to short a stock when it is dropping down.
Short selling involves a trader borrowing a stock from a broker and immediately selling it. The idea is to try and buy it back at a lower price before returning it to the broker. This trading strategy is one of the most common ways in which day traders can bet on a stock falling in price.
But short selling has long been controversial. Mainly because it pits hedge funds and other traders against companies.
The short selling rule restricts short sellers from jumping into a stock whose shares have slumped by 10%. Once your broker triggers the rule, it becomes impossible for you to short the stock since the restriction remains for the remainder of the day.
The rule applies to all stocks listed in U.S. stock exchanges like Nasdaq and the New York Stock Exchange (NYSE). However, the rule does not apply to futures traders who can short futures as many times as they want.
Bottom Line
The hope of making quick profits in the stock market with a just few clicks of the mouse from the comfort of your home is perhaps the main reason why people engage in day trading.
It’s possible day traders can make profits consistently. However, this activity requires not only adhering to of a trading methodology but also abiding by regulatory rules.
If you are determined to take a shot at day trading, you need to learn and understand day trading restrictions.