Of the many different types of traders in the stock market, one type is called the pattern day trader. To understand how to rise above the PDT rule, this article will first explain how a pattern day trader works, what the rule is, and how to trade effectively, knowing the subtleties of the rule.
Who is a pattern day trader?
A who executes a large quantity of short and long trades to take advantage of intraday market price changes is called a day trader. They make profits due to price changes of a given asset arising due to market supply and demand inefficiencies.
A trader or investor is called a pattern day trader if he or she executes four or more day trades during the five business days, in a margin account. The number of day trades executed must be more than 6% of the margin account’s total trade activity during the five business days. Note that sometimes a day trade is also called a round trip i.e., buying and selling the same stock on the same day.
Now, pattern day traders have no limit to how much they can trade, so the pattern day trader rule was established to discourage excessive trading activity by the investors.
What is the pattern day trader (PDT) rule?
The pattern day trader rule says that the Financial Industry Regulatory Authority (FINRA) mandates that the pattern day traders must have a minimum of $25,000 equity in their brokerage (or margin) accounts, either as cash or certain securities or a combination of both.
If the value of equity drops below the threshold, the pattern day trader can execute only three-day trades every five days. If this is violated, the trading activity in that account is frozen for 90 days or till the amount is brought back above $25,000.
Motivation behind the rule:
Day trading was at its peak in 1999-2000, and the NASDAQ index shot up rapidly above 5000 points. This massive boom happened thanks to excessive day trading, overvalued IPOs (Initial Public Offerings), and short squeezes (i.e., the sudden increase in the price of a stock due to supply-demand discrepancies rather than the fundamental value of the stock).
When the bubble burst soon after, in the mid-2000s, many retail investors (people buying and selling stocks for their accounts) suffered heavy losses.
To prevent the retail investors from making the same mistakes again, the Securities Exchange Commission (SEC) brought about the pattern day trader rule. The assumption here was that investors with $25,000 would be familiar enough with the risks associated with day trading.
Moreover, the rule also increased the buying power from 2:1 up to 4:1 margin requirement i.e., if you have $x in the margin account, you can purchase up to $4x worth of stock.
Tips for traders under the pattern day trader (PDT) rule
As a pattern day trader, you want to be in a position where you are still able to trade in large quantities but without violating the rule. Luckily, there are some legal workarounds to avoid the rule and to trade when you do not have enough account balance.
Keep track of your round trips: Keep a calendar aside just to make a note of when you have made your day trades because you are allowed only a maximum of three in a five-day window. A fourth trade is possible if it an overnight trade (after the close of exchange and before it opens the next day), but some platforms will automatically restrict this as a safety measure.
1. Set strict goals… and stick to them:
The commonly-used 80-20 rule applies even to stock trading: 80% of your income is likely to come from 20% of your trades, so choose your trades wisely. Keep a goal in mind as to what exactly you want to achieve through day trading: what are you going to do with your earnings?
If you have only three trades a week, decide if you are okay with putting your goal on the line for those trades, and only then execute them.
2. Using a cash account:
This is a sure-shot way of avoiding the rule, but you can only use settled funds. This means that when you buy or sell a stock in a cash account, the money takes two days after the trade date to settle and only then you can use them again for your next trade.
If you have $20,000 in your cash account and you use $4,000 to trade on a Tuesday, you can’t use that money until Friday, but you can use the remaining $16,000 to trade on Wednesday and Thursday.
3. Swing trading:
Swing trading is when an investor holds a long or short position for more than one trading session (but not more than a few weeks). In general, swing trading is used to capture a large price change, and the investor holds on to the stock until the required price move occurs.
It is used as an escape strategy here because if you hold a stock for more than one session, the trade will not be considered as a round trip, and therefore, the pattern day trader rule will not apply.
However, swing trading requires a lot more patience than intraday trading because of the inherent risk of longer holding periods.
4. Futures trading:
A futures contract is an agreement between a buyer and seller to trade an asset in the future at a fixed price and date. Pattern day trader rules do not apply if a trader deals with futures i.e., day trading is still possible without the minimum balance of $25,000.
It’s your turn to trade!
If you were intrigued by the concept of pattern day traders or stock trading in general, check out some of the online virtual stock trading platforms. As a user, you are given a virtual sum of money and a free brokerage account to buy and trade stocks, giving you an idea of what it is like in the real market.