Pattern Day Trader (PDT) rule has been enforced by the Securities and Exchange Commission (SEC) on traders who execute four or more day trades in their margin account within five business days.
A day trade is when you buy or short security and later sell or cover that security within the same day itself.
Consider this; if you have a $5,000 account, you are only allowed to execute three-day trades in any rolling five-day tenure. Once your account worth crosses $25,000, you are no longer bound by this restriction.
The violation of this rule doesn’t have to bother you as your broker would notify you before the potential violation. Your brokerage account can be frozen for 90 days in case you don’t heed to their warnings.
History of the Pattern Day Trader Rule
The PDT rule was enforced back in 2001 as a safety feature to mitigate risks during trading.
During the dot-com boom in the late 1990s, the trend of trading exploded in popularity. Traders from this era claimed that it was as simple as purchasing IPOs on the first day, and anticipating a 20% pop in stock prices.
With the hit of the new millennium, the dot-com bubble burst and the day traders who had entered the domain of trading during the late 1990s era eventually went broke.
Day trading was condemned by politicians and the media, to which the SEC and FINRA responded. They implemented the PDT rule in February 2001 with the ideology of safeguarding the investing public.
Impact of PDT on Trading
Once your account is entitled as a pattern day trader, it becomes paramount that you maintain a minimum of $25,000 in equity in your account.
On the bright side, you possess a higher buying power. For non-day traders, you are entitled to merely 2:1 buying power while as a day trader, you receive 4:1 day trading buying power.
To put that into perspective, if you possess $25,000 in your account, you own $100,000 to trade within day trading buying power.
Day trading buying power, as the name suggests, can only be implemented on day trades as you are not eligible to hold positions overnight. You also have to start the day with $25,000 in it for the day trading.
The rule for starting the day with the $25,000 minimum is strictly imposed. You cannot even hold $24,500 at the beginning of the day and eventually sum it up to $25,000 later.
If you use a regular cash account, you are eligible to indulge in as many day trades as you wish until you don’t run out of cash.
However, you must wait for your trades to settle before putting cash into investments again. This usually takes three days from the trade date for stocks and one day for options from the date of the trade.
You also would be incompetent to use leverage as you wouldn’t have any buying power for the time being.
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Consequences of Violating The PDT Rule
For first-time offenders, the consequences won’t be severe, considering that your brokerage has comparatively lenient rules.
However, you would be marked as a pattern day trading violator, so your broker would monitor your activities for repeated offences in the future.
If you make four-day trades in a rolling five days, some brokerages might have you deposit enough funds to hold at least $25,000 in your trading account.
Your trading privileges might be suspended for the next 90 days until then. You could only close out your positions and not be able to trade. Your margin buying power would limit you to cash transactions.
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Ways Around the PDT Rule
There are some ways that you can implement to work your way around the PDT rule –
· Multiple Brokerage Accounts
The major US brokerage firms these days have eliminated commissions, allowing even the least capitalized of traders to hold multiple accounts.
Considering that commissions have been eliminated from the domain of trading, it is viable to open numerous $100 accounts across many significant brokers.
· Join a Proprietary Trading Firm
The undercapitalized traders who are serious about trading as their source of living can take advantage of joining a proprietary trading firm. These trading firms are diverse, where each offers its pros and some cons.
Traders have the option to choose from three types of prop firms –
Leverage Stores – These firms are glorified brokers who provide more leverage. They would charge you for software and data, alongside which, some education would also be provided.
Mentor-based Firms – These firms hire people with trading experience and some track record. Primarily, they seek people who are passionate about trading and willing to learn.
These firms don’t demand deposits; however, you won’t receive a high salary or income during your training, thereby increasing the demand for alternative income sources.
Professional Firms – These firms are more inclined towards professionalism than any other firm mentioned above.
These firms deal with matters formally and sophisticatedly; however, they demand people with a qualified and well-experienced profile.
Most provide you with a salary along with a profit split but tend to seek people who are highly qualified with advanced degrees in expertise like math or quantitative sciences.
The PDT rule is often tedious to handle for new traders. It significantly affects the day trading in America as many traders unknowingly violate this law, thereby facing imminent consequences.
A new day trader can trade at their will and apply risk management principles, which can help them build a sample size of trades to build experience.
With the PDT rule enforced, the time taken to build a sample size becomes more protracted, as you are not allowed to trade each day.
PDT, however, has been enforced to safeguard the public from recklessly investing and losing their money.