If you are seriously considering Day Trading, there are certain rules, like Pattern Day Trading, that you should know. Failure to adhere to these trading rules may have financial consequences. One of these rules is the Pattern Day Trading rule. This article shall define the Pattern Day Trading Rule and tackle how and where it applies.
So, pay attention and let MyTrade help you stay in the black.
What is the Pattern Day Trading Rule?
According to FINRA rules, if you execute more than 3-day trades within any five-business-days period and these correspond to more than 6% of the total trades on this account during the same period, you’ll be considered a Pattern Day Trader. A day trade consists of two transactions within the same financial instrument on the same day of trading.
This rule was established by the Securities and Exchange Commission (SEC).
Let us assume that you have an account worth $5,000. In this account, you execute four-day trades over five business days. In such a case, the Pattern Day Trade Rule Applies to you. Once your account’s value exceeds the $25,000 mark, you can execute as many day trades as you wish. But, in this case, you’ll have to begin the day with a minimum of $25,000.
To prevent traders from violating this rule by accident, most brokers notify their customers. Ignoring such warnings will attract a suspension of your account for 90 days.
Pattern Day Trading Rule: Background
The PDT rule came into effect back in 2001. The rule was established as a safety feature to help traders minimize the risks of day trading. The Dot-Com boom of the late 1990s attracted many traders who aspired to try their hands in day trading.
As the new millennium approached and the Dot-Com Bubble popped, regular folks, turned full-time traders with little education and experience lost everything. Politicians and the media vilified day trading, and the SEC and FINRA had to step in. The change came in February 2001 when they commissioned the Pattern Day Trader rule.
Pattern Day Trading: Who and When it Applies
Once your account is identified as one that belongs to a Pattern Day Trader, you are required to maintain a minimum balance of $25,000 in equity. The main advantage is the rule ensures that you always have great buying power.
A day trader will enjoy a buying power of 4:1 while a non-day trader only gets 2:1 buying power. For a day trader, an account that holds $25,000 will feel like it is worth $100,000. You can only use this buying power on day trades. You cannot enjoy the privilege of trades that run overnight.
For regular cash accounts, you can place as many day trades as you want until your exhaust your cash. The only catch in such accounts is that you have to wait for your trades to settle before using the funds again. It takes three days for stocks, while for options, you will have to wait for a day.
Cash accounts do not enjoy any of the buying power you would have as a pattern day trader. In other words, you cannot use leverage.
Loopholes and Ways to Get Around the Rule
There are several ways to get around the Pattern Day Trader Rule.
- Open Multiple Brokerage Accounts
Since many US brokers are eliminating commissions; you can take advantage of the situation and open multiple accounts. In the past, this strategy was not feasible. The $5 commissions and fees spread across different accounts would eat up your capital.
Today, you can open several $100 brokerage accounts with different brokers and not suffer the sting of commissions and fees. Additional accounts mean that you have other three day trades rolling per five business days.
- Join a Proprietary Trading Firm
This option is suitable for the undercapitalized trader who would like to get serious about trading. Proprietary firms come in all shapes and sizes. Each type offers a unique set of pros and cons.
Below are the three types of proprietary firms available:
- Leverage Stores: Such firms are glorified brokers that offer you more leverage. Leverage stores will charge you for data, software, and the education they provide.
- Mentor-Based Firms: These firms are suitable for traders with some experience. They look for traders who are passionate about their craft and willing to learn. Mentor-based firms will not require a deposit from you but to go without much of your earnings during your training period.
- Professional Firms: Most firms of this kind pay a salary in addition to a profit split. Such firms hire people with advanced degrees in disciplines like math, quantitative sciences.
The Pattern Day trader Rule is a headache for day traders who are new to the craft. This rule takes longer to build a sample size as it limits you from trading every day. As things stand, the PDT rule is a fact of life, and it is a reality that we must accept.