Day trading is a highly regulated activity in the United States and other countries. These regulations became more prominent after the dot com bubble. At the time, most people in the US were active day traders.
As a result, government agencies like the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) came up with several regulations in a bid to protect retail traders. In this article, we will look at a key regulation that came up during that period. It is known as the pattern day trader (PDT) rule. We will identify what it is and how to avoid it.
What is a pattern day trader rule?
A pattern day trader rule affects a good number of traders in the United States. The rule simply states that people who open four trades within five days in a margin account should be classified differently. In this case, they should be classified as pattern day traders.
There are a few exceptions to this rule. In the definition above, it is essential to note that it refers to a margin account. For starters, a margin account refers to an account that has some leverage. Leverage is a certain amount of money that brokers provide to investors to amplify their profits.
For example, if you have a $10,000 account, a broker can extend you a similar amount of money. With these funds, you can open more trades and make more money when things are going right. On the other hand, if your trades go south, you will find yourself losing more money when your margin call is triggered.
A margin call differs from a cash account. A cash account is not levered. As such, if you have $10,000 and stock is trading at $50, the maximum that you can buy is 200 shares. Therefore, you don’t qualify as a pattern day trader when you have an ordinary cash account.
Another exception of the PDT rule is the representation of your trades. For you to be considered a PDT, the total size of your trades needs to be about 6% of your total margin account.
Why does the PDT rule exist?
Like many other rules in existence today, the PDT rule is designed to protect ordinary traders. Regulators believe that overtrading is one of the most common reasons why traders blow their accounts. Therefore, after a period of studies, they noted that, on average, the optimum number of trades that a trader can implement is 4.
Many traders hate this rule, and later on, I will look at some of the popular ways of avoiding the PDT rule. Still, in my experience, I have come to believe that four trades per week are adequate for most traders. This is especially the case among many retail traders who have full-time jobs.
Implications of being declared a PDT
We have looked at who qualifies to be a pattern day trader. Still, it is worth noting that brokers have the discretion to classify you as a pattern day trader for their own reasons. For example, if a broker provides you with day trading training, it can classify you as a PDT. Alternatively, if it observes your trading techniques, the broker can classify you as a PDT.
Several implications happen when you fall under PDT rules. For one, if you are classified as a PDT, you will need to maintain an account balance of $25,000. If you don’t have these funds, then the broker is at their discretion to lock your account for 90 days.
It is worth noting that a week does not need to be from Monday to Friday. For example, if you open two trades on Thursday and Friday and then two more trades on Monday and Tuesday, then the broker has a right to declare you as a pattern day trader.
Another important thing is that the broker will still refer to you as a PDT even when you stop the practice. For example, if you are classified this week and stop trading for a while, you will still be a PDT when you come back.
Ways of avoiding the PDT classification
There are several strategies to avoid the PDT classification. First, you can avoid using margin in trading and use a cash account. Indeed, many experts believe that a cash account is better for most beginners.
For one, in a worst-case scenario, the maximum amount of money you can lose is all your funds. In a margin account, you can lose more money than what you deposited initially. This happens when your broker does not have a negative balance protection feature.
Another benefit of a cash account is that you can open as many trades as you wish. This explains why there are many traders today.
Second, you can avoid this classification by creating accounts with several brokers. Fortunately, there are many brokers in the United States today. Some of the most popular ones are Robinhood, TD Ameritrade, Schwab, and SoFi. With these brokers, you can open a maximum of four trades in a given week.
Third, you can become a prop trader. A prop trader is one who uses the funds of another company to trade. Some of the most popular prop trading firms you can use in the US are Day Trade the World (DTTW), FTMO, and Lux Trading Firm. As a prop trader, you will receive a sizable commission for all your profits.
Finally, you can avoid being classified as a PDT by just playing according to the rules. This means that you can open just a few trades per week. Besides, when done well, opening just a few trades can be highly profitable.
In this article, we have looked at the concept of Pattern Day Traders (PDT). We have explained why the rule was introduced, how it works, and what happens when you are classified as a PDT. Most importantly, we have looked at ways of avoiding the rule.