Day traders are often glamorized within television and movies. The image of a day trader is one who engages in the market incessantly throughout the day and drives off in a Porsche or other luxury sport sedan after work to meet his beautiful companion for drinks and dinner. In reality, daytrading is an extremely difficult endeavor, and one that should not be taken lightly. There are many hurdles to successfully trading the markets on a very short-term time horizon. Due to the increased risk associated with daytrading, laws have been enacted within the United States to protect both day traders and their brokers.
Pattern Day Trader Designation
The pattern day trader, also referred to as PDT, is a designation given to traders that execute four or more day trades within five trading sessions and do so in a margin account. Additionally, the total day trades must account for more than 6% of the account value during the same time period. These pattern daytrading rules apply to stock and stock option trades. If and when this occurs, a trader will be flagged as a pattern day trader by their broker, which will subject them to various requirements and restrictions.
The actual pattern day trader designation falls under the rules of the Financial Industry Regulation Authority, or FINRA. Based on FINRA’s PDT rule for equity trading, it requires that pattern day traders must maintain a minimum of $25,000 within their brokerage account.
If at any time, a trader’s account falls below this minimum threshold, they will no longer be able to execute any further day trades within their account until such time as they replenish their account to meet the minimum threshold set by FINRA. The $25,000 value as described above can be in the form of cash, stocks, or other acceptable securities. Furthermore, the $25,000 minimum value is based on the closing balance of each day rather than an intraday value.
Once your account has been flagged or marked by your broker as a PDT account, this designation will continue for a period of 90 calendar days. As such, you will not be able to execute any day trades within your margin account for a period of 90 days unless and until your portfolio value is at or above the $25,000 threshold. Some brokers may have slightly different rules, however, for the most part they will be along the same lines.
It’s also important to note that the number of trades is based on actual execution of an order rather than merely a placement of an order. That is to say that you could place multiple orders in the market, however, unless and until that order is executed, it will not count against your completed trades.
Pattern Day Trading Example
Let’s illustrate a few examples of the pattern daytrading rules to better understand how it works.
Let’s assume that Henry has a $5000 trading account within a margin brokerage account at TD Ameritrade. On Monday, Henry places a day trade on Cisco stock, buying in the morning and selling the entire position mid-afternoon. On Tuesday he places a day trade on Microsoft stock, buying in the mid-afternoon and selling a half-hour later. Then on Wednesday, Henry places a day trade on Amazon stock, buying at the open and selling the entire position in the early morning session.
By Thursday Henry has placed three completed day trades, and as such if he places another day trade on Thursday or Friday, he will likely be flagged as a pattern day trader. So, what must Henry do in order to avoid being marked as a pattern day trader in this case? Well, the most prudent course of action for Henry would be to wait until at least the following Monday before placing any additional day trades in the market. Doing so will allow him to bypass the pattern day trader classification in this case.
If, however, Henry initiates another day trade either on Thursday or Friday, he will be flagged as a pattern day trader by his broker. This is assuming that his day trades from Monday through Wednesday accounted for more than 6% of the total value within his trading account. In most cases, he would be warned about his activity and provided with clear ramifications for his continued daytrading activity given his account size. In other words, after the initial warning, if Henry continues daytrading beyond the limits set by the pattern day trader classification, he could risk having his account frozen for a period of 90 days based on the rules set by FINRA.
Pattern Day Trader Restrictions And Requirements
As we have noted thus far, the minimum required capital needed for those traders designated with the pattern day trader status is $25,000. This should not be confused with the minimum equity requirement of $2000 required which was set back in the early 1970s. The $2000 equity requirement was intended to be applied to intermediate-term and longer-term investors. As such, it did not have much application for the short-term day trader. Keep in mind day trading very fairly rare prior to the advent of the electronic trading era.
As such, any losses resulting from daytrading needed to be dealt with in a more practical manner. The pattern day trader rule brought on higher minimum equity requirements for day traders to ensure brokerage firms would not be on the hook for their customers who engaged in very short-term daytrading activity, which could result in large losses.
Many brokerage firms believed that the suitable minimum account size for an active day trader should be set at $25,000. And as such this is where that figure originates from, and which is now set within the rules of FINRA. Some brokerage firms however go beyond this amount and require their daytrading clients to have deposit on hand in excess of $25,000.
Although traders can use the cash and securities within their account to meet the minimum PDT requirement, they cannot combine multiple accounts within a brokerage firm to meet this requirement. That is to say that a pattern day trader must hold the $25,000 minimum funds within a single account, regardless of the aggregate amount of funds they have on hand across multiple accounts at their brokerage firm.
Many traders that fall within the PDT requirements often lament about the rule and its level of unfairness as they see it. Regardless, the rules are in place and need to be adhered to in order to avoid any issues with your broker or with the regulating body. There is one big advantage that a day trader has that can offset some of these inherent drawbacks to the PDT stock rule.
Specifically, as a day trader you can benefit from an increased level of leverage in buying power. Typically, a day trader can utilize up to four times the buying power as compared to a traditional cash account holder. This can help amplify returns in a dramatic way, but keep in mind that leverage is a double edged sword, and it will act to amplify losses as well.
Getting Around The Pattern Day Trader Rule
Now that you have a better understanding of the pattern day trader rules, and the minimum account size requirement that go along with it, you might be wondering if there are any viable options in case you are not able to meet the $25,000 minimum requirement. Well, there are a few ways that traders can bypass the PDT requirement. Below you will find a few options to consider.
Execute A Maximum Of Three Daytrades Per Five Days – If you only make three day trades or less within a five day time window, you will not be subject to the PDT status. As such, this option would mean that you could still day trade, but your trading volume would need to be sufficiently less than what most day traders engage in. If you have a strategy or system that trades only a handful of times per week, then you may be able to make this work. But even assuming your daytrading strategy calls for initiating one trade per day, that would equate to five trades a week, thus opening you up to the pattern day trader designation.
You could implement additional filters into your daytrading strategy in order to reduce the number of trades per week to stay within the FINRA requirements. In some cases, filtering your trades more may allow you to improve your system, while reducing your overall trading costs. Though this is certainly not going to apply in all cases, it’s worth researching further as it pertains to your specific daytrading system or strategy.
Consider An Offshore Broker – The PDT rules outlined here pertain to US-based traders that fall under the authority of FINRA regulations. As such, one way to get around the PDT trading rule is by tapping into equity markets outside of the United States. There are a wide array of very liquid stock markets around the world including those of Canada, Germany, United Kingdom, Australia, Japan, Singapore and more. Since brokers in these jurisdictions fall outside FINRA regulations, you will likely be able to bypass the day trade pattern rule as it applies to US-based brokers. However, do not always assume this to be the case, as laws are ever-changing and certain jurisdictions may have agreements amongst each other with regards to this.
Join a Proprietary Daytrading Firm – There are quite a few proprietary daytrading firms that are in existence as of this writing. Many of these firms provide both infrastructure and other support for aspiring day traders. One great benefit of joining a day trading firm is that you can often deposit less than the $25,000 requirement and utilize their capital to speculate in the market. Each proprietary day trading firm is different and will have their own corporate guidelines for dealing with its daytrading partners. However, it’s a viable choice for those that are looking both to learn, and that require assistance with accessing capital to trade.
Transition To Swing Trading or Position Trading – So far, we’ve discussed the mechanics of the PDT rule, without discussing much in the way of daytrading strategies and methods. That is a deep subject in and of itself, however, those that are experienced in this area know that the costs and frictions associated with daytrading can be quite cumbersome. That is to say that making consistent profits from daytrading equities can be quite challenging to say the least.
One of the best ways to reduce costs and frictions associated with daytrading is to switch to a more longer-term trading horizon. This could come in the form of swing trading, which is more of an intermediate term style of trading. Swing traders generally hold positions for several days to several weeks. Additionally, traders can consider an even longer-term horizon by implementing a position trading approach. Position traders generally hold trades for several weeks to several months if not longer. And so, by transitioning to a longer term time horizon, you can bypass all of the PDT related rules and regulations.
Open An Account With Multiple Brokers – To avoid the pattern day trader rule, you may consider opening multiple brokerage accounts. For example, if you plan on daytrading stocks with $10,000 and you have figured out that your trade frequency will be one trade per day, or five trades per week, then instead of placing your $10,000 with one brokerage firm, you may want to split that up and place $5000 at two brokerage firms. This way, if you require five day trades per week you will be able to do so across these two accounts without triggering the PDT designation. In other words, you might place three day trades within one brokerage account, and then two day trades within the second brokerage account. This will allow you to stay under the radar while achieving your daytrading requirements with your capital base.
Switching To A Different Market For Day Trading
We discussed some of the ways that undercapitalized traders can try to avoid the PDT FINRA rule. Some of these ideas might resonate with you, while others may not be feasible. One other consideration that we have not yet discussed, but deserves attention is transitioning from daytrading the stock and stock options market to another more favorable venue for daytrading. Remember, the PDT day trading designation only applies to the equity markets; no such rule applies to the other markets that we will discuss shortly.
Many traders and investors who start off in the financial markets tend to do so within the context of the stock market. There are many reasons for this, but the fact remains that new traders and investors are most familiar with the equities market and thus gravitate towards that market over others.
There is nothing intrinsically wrong about doing this, however, those traders that will ultimately want to take a shorter-term view in the market through daytrading activities need to be aware of the drawbacks of the PDT status. Here are some alternative markets that stock market day traders should keep an open mind about, particularly if they fall under the pattern day trader umbrella.
Forex Market – The foreign exchange market is the largest market in the world. Currencies trade in pairs, meaning that you are betting on the movement of the exchange rate, which is comprised of two currencies traded against each other. Although trading currencies may seem daunting to newcomers, many of the mechanics of trading currencies are similar to that of the stock market.
However, instead of betting on the direction of a specific stock or ETF, you are betting on the price movement of the exchange rate. Within most jurisdictions outside the US, you can open a Forex brokerage account for less than $500 and enjoy leverage up to 500 to 1 or more. Within the United States, there are just a handful of Forex brokers, and most offer opening accounts starting at around $2000 or so. The leverage at US-based Forex brokers is generally capped 50 to 1.
Futures Market – The futures market is an extremely popular venue for day traders. Most futures brokers offer their clients access to stock index futures, agricultural commodity futures, metal commodity futures, interest rate futures, currency futures, and more. By far the largest and most influential exchange within the United States is the Chicago Mercantile Exchange, CME. Trading futures has many advantages over other markets.
Futures daytrading margins can be very nominal compared to the traditional equities market, and traders can go short just as easily as they can go long. This is a big advantage that should not be taken for granted. Although traders and investors can go short in the traditional US equities market, they do have to contend with the uptick rule which requires that a short position can only be executed on a higher tick.
Summary
Daytrading is a very popular style of stock trading especially for novice market participants. These traders would do well to understand the rules and regulations as it applies to equity daytrading. The two that are of most importance include the uptick rule, which limits the ability of traders and investors to sell short the market. The second rule is the one that has been the focus of this article. Specifically, the pattern day trader rule. Going into the equity daytrading arena without fully understanding all the implications would not be advisable to say the least.