As a trader, you owe it to yourself to gain a thorough understanding of the basic rules and concepts that dictate the parameters of your trading. Sure, developing a great trading strategy, finding the right stocks to trade, and understanding risk management are all vital to your overall success as a trader. However, if you aren’t familiar with the rules and regulations that govern the financial industry, you will truly be at a disadvantage.
One of the most common rules that throw new traders off is the PDT rule, also known as the Pattern Day Trader rule. In this article, we look at what the Pattern Day Trader Rule is and how to avoid violating it with your trading habits.
Pattern Day Trader Defined
Before we jump into what the pattern day trader designation is, it’s important to understand what a day trade, also known as a “round trip trade”, actually is. A day trade is defined as the purchase and sale of a security in a single day. Day traders try to capitalize on intraday price movements of a security. You can absolutely execute day trades without being designated as a pattern day trader, but you need to know the rules in order to do so.
The pattern day trader designation occurs when someone executes four or more day trades during a five business day period in the same margin account. Whenever you are designated as a pattern day trader, FINRA requires you to have a minimum of $25,000 combined value in securities and cash in your brokerage account as a means of mitigating risk. If your account equity drops below that $25,000-dollar threshold, you will not be able to complete any day trades or opening trades until your account goes back above the threshold.
You might be wondering what happens to your account if you are flagged as a pattern day trader and you aren’t even close to the $25,000 threshold. After all, the majority of new traders aren’t able to begin their trading journey with a $25,000-dollar account. In that scenario, your account would be restricted to cash-only status for a 90-day period. That means you will only be able to place closing trades in your account until the restriction is lifted.
As you can imagine, this can be extremely frustrating for new traders that want to continue their progress in the market. However, FINRA created this rule to help protect inexperienced investors from trading too often. It is intended to protect people from overtrading and blowing up their accounts.
How to Avoid the PDT Rule
Now that we know what the PDT rule is and why it exists, it’s time to learn about how to avoid it entirely. The simplest way to avoid being negatively impacted by the PDT rule is to have a margin account with an equity value of over $25,000. Just make sure your account value stays above that threshold during your day trading and you will not have to worry about PDT at all.
Another way you can avoid the PDT rule is to keep track of your day trades at all times. Keep in mind that the PDT rule applies to trades within a 5 business day period. It’s a rolling 5-day trading period, meaning that the total number of day trades drops off over time. So your goal is to keep your total day trades below four during the rolling 5-day period. This can be a good way to approach trading, especially if you are new because you will use your day trades more sparingly. Just the idea that you are limited to a certain amount of day trades you can do each week can be valuable to you as a trader, as you will only want to take the best possible setups.
Another good way to avoid the PDT rule is to incorporate trading strategies that don’t require you to execute day trades. For example, swing trading is a great way to make money on price fluctuations without ever having to worry about the PDT rule. Since swing trading typically involves keeping your trades open overnight, you won’t be executing any day trades. Keep in mind that day trading and swing trading strategies are very different, so make sure you are doing your research and backtesting your systems before putting real money on the line.
Even though many new traders end up hating the PDT rule, we should always keep in mind that it was designed to help us. Remember to keep track of your account equity and the total number of day trades in your account to avoid having to deal with the ramifications of this trading violation.