The Pattern Day Trader (PDT) rule is an important and yet misunderstood concept in the United States. The rule was introduced by Congress and is currently overseen by the Financial Industry Regulatory Authority (finra).
In this article, we will look at what the PDT rule is and what you need to know about it.
What is the Pattern Day Trader Rule?
A pattern day trader is defined as a person who implements four or more traders in five days in a margin account. So, it is important for you to understand what a margin account is since this is an important part.
A margin account is defined as a trading or investment account that uses leverage. Leverage is an amount of money that a broker extends to a customer in order to maximize their trades. For example, if you have a $1,000 account and your broker has a 1:50 leverage, it means that you can trade with about $50,000.
Therefore, if you have an ordinary Robinhood account and you execute more than four trades in a week, you cannot be defined as a PDT. This is because you are not using a margin account.
The PDT rule states that a trader who opens more than 4 trades in a week in a margin account must always maintain a minimum balance of $25,000. Obviously, this is a relatively higher amount for most traders.
The genesis of the PDT Rule
The PDT rule was implemented in the aftermath of the dot com trading bubble. At the time, many people were engaged in making money through day trading. As a result, most of them lost a substantial amount of money. Therefore, regulators implemented the rule to protect and disincentivise people from day trading.
» Related: Are we in a stock market bubble?
Example of a Pattern Day Trading
While there are several scenarios of when the PDT rule kicks in, let us look at a simple one.
So, it is on a Monday morning and you buy 200 shares of a company and sell them before the end of the day. This is a day trade since you have ended the day with zero shares of the company. Therefore, if you open similar trades four times in a week from your margin account, the PDT rule kicks in.
On the other hand, if you buy and sell shares of a certain company four times on a Monday morning, you are a pattern day trader.
Cash vs margin account
As mentioned above, the key point in the definition of a PDT is margin account. Therefore, let us look at the top differences between a cash and a margin account.
When you have a cash account, it means that you will implement all your trades with the cash that you have. For example, if you have $25,000 account, it means that you can only buy stocks worth that amount in a given period. Many brokers, especially Interactive Brokers, will always ask you the type of account that you want to create.
There is one major benefit of having a cash account. In it, the maximum loss you can make is all your money.
On the other hand, with a margin account, you can lose more money than your real balance. This is simply because margin means that the money is borrowed.
» Related: Margin Trading: guide + risks involved
The main challenge for using a cash account is that you will not be able to take full advantage of the financial market. That’s because you are limited to the funds that you have in your account.
A margin account, on the other hand, allows you to make bigger wins by having more money to trade with. The biggest risk is that you can lose your original investment and the borrowed cash, which you will have to pay.
A minimum margin is the minimum cash deposit in your margin account. Other key concepts you need to know are the initial margin, maintenance margin, and a margin call. A margin call is when the broker aks you to increase the amount of money in your account. This happens when you are making a big loss.
PDT rule restrictions
There are several restrictions that can set in when you break the PDT rule in the market. For example, the New York Stock Exchange (NYSE) states that if you have an account with $25,000, it is frozen for about 90 days.
Some brokers have come up with approaches to prevent this from happening. For example, Interactive Brokers has algorithms that prohibit accounts with less than $25,000 from opening the fourth account.
How to avoid the PDT rule
Fortunately, there are several strategies you can use to avoid the PDT rule. First, you can avoid using leverage in your trading. When you don’t have leverage, it means that you can execute as many trades as you wish. Indeed, we recommend that most trader should avoid using margin because of the risks involved.
Second, you could join a prop trading firm like Day Trade the World (DTTW). These are firms that give you capital to trade and then you share the profits. We highly recommend that many traders should use this option because of its additional advantages like having more trading capital.
» Related: What is proprietary trading
Third, you can use multiple brokers if you are really interested in implementing many trades in a week.
Additionally, you can remain within the confines of the PDT rule. This means that you should only open less than four trades per week. In fact, we highly recommend that many new traders should avoid making more than four trades per week.
There are other ways of avoiding the PDT rule. These include having a watchlist, using a trading journal, and even becoming an investor. An investor is someone who buys and sells stocks within a long time.
We thought it was necessary to clarify what a pattern day trader was, because this definition creates a lot of confusion especially for those who want to pursue a career as a trader.
Indeed, in this article, we have looked at what a PDT rule is, how it works, why it was implemented, and some of the best strategies to avoid it.