The pattern day trader (PDT) rule may affect you whether you know it or not.
The PDT rule was put into place by the SEC on September 28, 2001 and affects your ability to make day trades.
In this guide, I want to show you exactly who is affected by the pattern day trader rule and ways you can avoid triggering pattern day trader status.
Let’s dive in.
What's The Pattern Day Trader Rule?
The pattern day trader rule can be confusing for many traders but it affects you regardless.
In fact, the day trader rule can cause you to get a margin call from your broker if you are not careful.
The question is:
What’s the PDT rule? And how can you avoid it?
What Does It Mean To Be A Pattern Day Trader?
A day trader is a trader who buys and sells (or shot sells and buys) the same security within one trading day in a margin account.
The PDT rule comes into play when you execute a day trade more than four times in a rolling 5-business day period.
This rule does not apply if you hold the security overnight and exit the trade the next trading day.
But the PDT rule does apply to short sales and options positions.
The second criteria for the rule is if day trades make up more than six percent of your total trading activity in a rolling 5-business day period.
If you do trigger the pattern day trader rule, you must maintain a minimum of $25,000 in equity in your trading account.
If your trading account has less than $25,000 in equity and you trigger the PDT rule, you will be issued a margin call, requiring you to add more fund to your account.
Until you add more funds to your account, you will be restricted to 2 to 1 leverage for you day trades (instead of the typical 4 to 1 leverage).
If you don’t add more funds to your account within 5 business days, you will be restricted to cash trading only, so you won’t have access to any margin for 90 days or until you add the funds.
Day Trade Examples
Here are some examples that are considered day trades:
You start with 0 shares of XYZ stock.
You buy 1 ABC, then you sell 1 ABC.
This is considered one day trade and would trigger the PDT rule.
You start with 10 shares of XYZ stock.
You sell 10 XYZ, buy 5 XYZ, sell 5 XYZ.
This is only considered one day trade because the initial 10 XYZ was from the previous trading day.
You have 10 shares of XYZ.
You buy 2 XYZ and sell 10 XYZ.
This is considered one day trade since you already owned 10 shares from a previous trading day.
You have 0 shares of XYZ.
You buy 1 XYZ, buy 3 XYZ, buy 1 XYZ.
Then you sell 4 XYZ and sell 1 XYZ.
This is one day trade since there is only one change in direction between the buys and sells.
These examples would all trigger the pattern day trader rule if you have less than $25,000 in your trading account.
Why Was The Pattern Day Trader Rule Created?
Now that you understand what the PDT rule is, why did the regulators create this rule in the first place?
That’s what you’ll learn in this chapter.
The Origin Of The Pattern Day Trader Rule
In the 1970s, the minimum equity requirement for margin accounts was only $2,000.
But this was before electronic trading existed, so day trading was very rare except among professional traders.
So, with buy and hold investors, $2,000 in equity requirement was sufficient collateral for the types of trading activities that occurred in that account.
But with the birth of online trading, day trading activities have become more prevalent.
And by the definition of day trading, the trader becomes flat at the end of the trading day meaning there is no collateral for the brokerage firm to protect from any trading losses.
Basically, day trading activities was view as more risky than buy and hold investing.
So, on September 28, 2001, the SEC and FINRA passed a rule to increased the minimum equity requirement.
This rule is meant to protect brokerage firms and yourself from margin calls and excessive trading losses from day trading activities.
Why Should You Care About The PDT Rule?
So, now that you have some background on this rule, why should you care about it?
Well, the reason is because of the fact that it will affect your trading activities if you are buying and selling securities intraday and if your trading account is less than $25,000.
If your main trading strategy is based around day trading stocks or options, then you better pay attention to this rule, otherwise you may find yourself with a surprise margin call.
Second, if you do classify as a pattern day trader, then you will have access to 4 to 1 leverage intraday.
This can be great for day traders because this means you can get a higher return on your capital for a smaller movement in the stock price.
Here’s an example:
If you have $25,000 in your trading account, that means you will have the ability to trade $100,000 worth of stocks intraday.
If you make 1% profit, then you effectively made $1,000 in trading profits.
But since only $25,000 is your own capital, you made 4% return.
This is a simple example of how leverage works.
Without a pattern day trader designation, you will only have 2 to 1 leverage, so your return in this case would only be 2%.
How To Avoid Being Classified As A Pattern Day Trader
Falling under the category of a pattern day trader puts a lot of limitations on the types of trades you execute, especially if you have a smaller trading account.
So, I’ve put together a list of ways you can avoid becoming a pattern day trader.
Let’s get started.
Avoid The PDT Rule By Trading Futures
Futures trading is exempt from the pattern day trader rule since they are governed by the CFTC, which does not have such a rule.
When trading futures contracts you even get access to a higher level of leverage (20 to 1) than what you would get with intraday stock margin.
The drawback to this approach is that there are a limited number of futures contracts available to trade, such as stock indices, agricultural commodities, and energy commodities.
You can trade futures on individual stock names.
Avoid the PDT Rule By Trading Forex
Similar to futures, forex is not governed by the SEC or FINRA so there is no such thing as pattern day traders in the forex markets.
In this case, you would have access to 50 to 1 leverage. But you would only have the ability to trade currencies in the forex markets.
The forex markets trade 24 hours a day during the week. In forex you would have access to trade assets like the euro, US dollar, and Canadian dollar.
So, if your trading strategy revolves around stocks, then this option won’t work the best for you.
Use A Cash Account
There are different types of trading accounts you can open at any brokerage firm. Some of these include margin accounts, portfolio margin accounts, IRA accounts, and cash accounts.
You can day trade without limitations if you use a cash account with no margin. If you have $10,000 in your trading account and make multiple day trades, you won’t trigger the PDT rule if you have a cash account.
If you go down this route, you won’t be able to get any leverage nor will you be able to short stocks or trade naked options.
This limits the amount of trades you can make since you are tying up 100% of the cost of the trade without any leverage.
Stick to Longer Duration Trades
There are bounds of opportunities in the market outside of day trading.
So, if the PDT rule is something that causes concern for you, then try your hand at swing trading.
Swing trades are a type of trade that you hold for longer than one trading day.
It could last several days or even weeks.
By taking this approach, you can stay involved in the market without triggering any day trading rules.
The downside is that if your exact trading strategy revolved around day trading, then this wouldn't work for you.
PDT Rule Frequently Asked Questions
In this chapter, I will answer some frequently asked questions when it comes to the pattern day trader rule.
Let’s get started.
Is Day Trading Illegal?
No, day trading is not illegal. Day trading is a common activity that many traders participate in where you open and close a position in the same trading day.
Restrictions come into play if you end up triggering the pattern day trader rule where you make more than four day trades in a rolling 5-business day period.
Then, you will be required to maintain a minimum of $25,000 in account equity.
Does The Rule Affect Short Sales?
Yes, the rule applies to short selling stock since you are in a margin account. It doesn’t matter if you buy and then sell or sell and then buy. It’s all considered a day trade.
Does The Rule Affect Options?
Yes, day trading options is also considered day trading. However, if you are in a cash account the rule does not apply.
Does The Rule Affect Futures?
No, the rule does not affect futures since futures are governed by the CFTC which does not have any day trading restrictions.
Day trade all you want!
Now It's Your Turn
So that's it for my guide on the PDT rule.
Now I want to turn it over to you: How does the PDT rule affect your trading?
Are you going to try to avoid triggering the rule? Or maintain a larger account equity?
Let me know by leaving a quick comment below right now.