What is the Pattern Day Trader Rule?
Pattern Day Trader (PDT) rule is a designation from the Securities and Exchange Commission (SEC) that is given to traders who make four or more day trades in their margin account over a five business day period. A day trade is when you purchase or short a security and then sell or cover the same security in the same day.
Essentially, if you have a $5,000 account, you can only make three-day trades in any rolling five-day period. Once your account value is above $25,000, the restriction no longer applies to you.
You usually don’t have to worry about violating this rule by mistake because your broker will notify you. If you ignore their warnings, they will freeze your brokerage account for 90 days.
The Pattern Day Trading rule was implemented back in 2001 as a safety feature to help reduce the risk associated with day trading as the previous rules were deemed insufficient.
Pattern Day Trader Rule Regulations
Once your account is labeled as a pattern day trader then you have to maintain at least $25,000 in equity in your account to make any day trades. The plus side to this is you will have more buying power available. For non day traders you only get 2:1 buying power but as a day trader you will get 4:1 day trading buying power.
So if you have $25,000 in your account, you will have $100,000 in day trading buying power to trade with for the day.
However, the day trading buying power can only be used on day trades as you will not be able to hold positions overnight when using it. Another important point to take note of is your account has to start the day with $25,000 in it.
The account can’t have $24,500 to start the day and then some of your holdings go up bringing your account to over $25,000 to get day trading buying power. It has to start the day with the $25,000 minimum.
If you are in a regular cash account then you can place as many day trades as you would like until your cash is used up. The only catch to this is you have to wait for your trades to settle before you can use that cash again and this takes three days from the trade date for stocks and one day from the trade date for options.
You also won’t have any buying power in your cash account so you won’t be able to use leverage.
History of the Pattern Day Trader Rule
During the dot-com boom of the late 1990s, it seemed like everyone became a day trader. The practice exploded in popularity, with many traders from the era admitting that it was as easy as buying IPOs on the first day, expecting 20% pops in stock prices. When the new millennium hit, the dot-com bubble popped and those everyday folks who became full-time traders with little education lost their shirts.
Day trading became vilified by politicians and the media, so the SEC and FINRA acted. They instituted the pattern day trader rule in February 2001 under the guise of protecting the investing public.
Example of the Pattern Day Trader Rule
Let’s say John has a $1,000 trading account. On Monday he day trades Apple stock, Tuesday he day trades Tesla, Wednesday he trades Exxon. He’s made his three-day trades, and won’t be able to make another day trade again until Monday.
However, he can only make one day trade on Monday, as he’s already made two-day trades within the rolling five-day period (Tuesday, Wednesday, Thursday, Friday, Monday).
If John tries to make a fourth day trade within the five-day period, his brokerage account will warn him of the consequences, and if he ignores them, his account will be frozen for 90 days, as per FINRA rules.
Ways Around the Pattern Day Trader Rule
There are several ways around the pattern day trader rule, and until recently, most of them were not ideal.
Open Multiple Brokerage Accounts
This option makes the most sense. Ever since the major US brokerage firms eliminated commissions, even the least capitalized of traders can open multiple accounts. Before, traders with $1,000 or $2,000 had trouble implementing this strategy. When you spread an already small account so thin, those $5 commissions really ate into your profits.
Now that commissions have been eliminated, you can open several $100 accounts across the major brokers: Schwab, TD Ameritrade, Fidelity, and E-Trade and trade in lots as small as you’d like.
Each additional account gives you another three-day traders per rolling five day period.
Join a Proprietary Trading Firm
This option is more suited to undercapitalized traders who’d like to get really serious about trading really quickly. Prop firms come in different varieties, with each offering their own set of advantages.
Generally, there are three types of prop firms:
- Leverage Stores: these firms are basically glorified brokers who extend you more leverage. Often they will charge you for software and data, and very little, if any, education will be provided.
- Mentor-based Firm: These firms typically look for people with some trading experience and a bit of a track record, but more importantly, they look for people who are passionate about trading and willing to learn. Most don’t require deposits but will expect you to go without much in the way of salary or income during your training, so savings or other income is required.
- Professional Firms: Not the above firms aren’t professional, but these are on another level. Most pay a salary in addition to a profit split, but they typically only hire people with advanced degrees in subjects like math or quantitative sciences. Jane Street Capital is an example of one of these firms.
Change Your Timeframe
If you’re reading this article, chances are you are more interested in day trading than swing trading, however, if the above two alternatives are not an option for you, than it’s better than nothing, isn’t it?
Former hedge fund manager and rock star trader Linda Raschke believes that the “real money” is made holding overnight, on the bright side.
The PDT is a headache for new traders. If a new day trader was able to day trade at their will and applied proper risk management principles, they can quickly build up a sample size of trades by which to learn from. With the PDT, it takes so much longer to build a sample size, as you can’t even trade every day.
With that said, the PDT is a fact of life that we must deal with. And on the bright side, the ubiquity of commission-free trading among the large discount brokers has made this rule far more palatable.