Anyone new to stock trading often gets blown by the hundreds of fancy terminologies and phrases that stockbrokers use every day. “Bear market,” “algo trading,” “peer correlation of stocks,” and other such terms are sometimes intentionally meant to confuse the layman. Although most of these terms are simple enough to understand when explained, one of the most complex concepts in stock trading is the PDT rule.
Pattern Day Trader: Definition
A day trader is one who executes a large number of trades every day to take advantage of the intraday price fluctuations. Their profit arises from the demand and supply inefficacies in the market.
One who executes four or more day trades during the five business days in a margin account is called a pattern day trader (a day trade is the same as a round trip, which refers to the buying and selling of the same stock within one day). Note that a margin account is one where all your cash is available to trade without delay. One constraint for pattern day traders is that the number of day trades must constitute over 6% of the margin account’s total trade activity during that five-day window.
What is the PDT Rule?
The Securities Exchange Commission (SEC) introduced the pattern day trader rule in the early part of the 21st century when retail investors faced heavy losses following a stock market bubble. This rule shifts the onus on the traders by limiting the trading frequency of day traders.
The Financial Industry Regulatory Authority (FINRA) requires that pattern day traders have at least $25,000 worth of equity in their margin accounts, either as cash or specific securities or a combination of both. If the amount falls below this, you can execute only three-day trades every five days. Violation of this will lead to the freezing of your account for 90 days or until the balance is above $25,000.
The rule also gives traders the flexibility of a higher buying power from 2:1 to 4:1 margin requirement. This ratio means that if you have $100 in your margin account, you are eligible to purchase up to $400 worth of stocks.
How Should Traders Deal with the PDT Rule?
Ideally, you never want to break the pattern day trader rule and halt all trading for nearly three months. However, there are legal workaround you can do to prevent this rule from applying to you or to cleverly manage your trading schedule if your balance does go below $25,000.
1. Use a Cash Account
A cash account is one where you make all transactions with available cash or long positions. Unlike margin accounts, you cannot borrow money against the value of the securities, and the money takes two days after the trade date to settle before you can use it to trade again. Most brokerages tend to persuade you to open a margin account when starting to trade.
However, the PDT rule does not apply if you operate using a cash account. You do not need to ensure a minimum balance in your account in this case.
2. Swing Trading and Overnight Trades
The rule applies only to intraday trades, and so, you can try swing trading as an alternative. If you hold a long or short position for more than one trading session, it is called a swing trade (if you hold it for one night, it is an overnight trade).
This tactic helps you avoid the PDT rule, but it no longer becomes a day trade where you can take advantage of price variations. Swing trading requires patience because traders usually hold on to the stock until a large enough price change occurs. Investors rely on technical analysis and simulation to predict the market movement, so this isn’t a tactic that rookie traders should try out.
A word of caution: if your balance goes below $25,000, some trading platforms allow you to make overnight trades if your account is frozen, but most of them ban trades in any form.
3. The 80-20 Rule
Although it seems tempting to execute more than three trades a week when your balance is below the threshold, you can earn a lot by executing just three trades. The 80-20 rule states that 80% of your income is likely to come from 20% of your trades. You can carry out those 20% trades under this restriction.
It is also good practice to plan what you want to do with the money you earn from day trades to take your risks appropriately.
4. Keep Track of Your Trades
Maintain a detailed record of all your day trades to force yourself to stop when you have made three of them. If the platform you trade on allows overnight or swing trades, keep track of those separately. Another good practice is maintaining a watchlist of some stocks that match your interest or criteria: you can track them to focus only on those stocks, limiting your chances of trading in excess.
5. Decide When to Trade
Another smart way of restricting your activities is to trade only in one timeframe, i.e., opening hours, midday, or closing hours. If you want to make the most of a volatile market, trade during the opening hours or closing hours since the midday period is typically idle. Trading actively towards the end of the session allows you to look for overnight trade opportunities.
If you have a day job, you can use the rest of the time to focus on that. If you are a full-time trader who is restricted by the PDT rule, you can read about the market, perform analyses, and carry out other crucial non-trading activities to make the most of your active hours.
Start Trading Today!
It can take a few weeks to a few months to thoroughly understand how stock trading works, and the best lessons learned are through practice and experience. Check out some paper trading apps available online that allow you to buy and sell stocks without using real money. Scenarios like the PDT rule are hard to simulate, but with enough virtual practice, you will be ready to face all aspects of the actual market.