Pattern Day Trading Rules Explained
The pattern day trading rule is a restriction imposed on retail investors. The law prevents traders from placing a certain number of trades over a short period. Understanding the restriction will help traders avoid legally required margin calls. By the end of this article, we’ll have explained what pattern day trading means, how to navigate the rules and where the restrictions apply.
What Does Pattern Day Trading Mean?
The pattern day trading rule was implemented by the US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) in 2001. The purpose of the rule is to protect day traders from the risks associated with leveraged retail trading accounts. Customers who are day trading must demonstrate they can afford to cover losses when trading on margin.
Pattern Day Trading Rules
The definition of a pattern day trader is when four or more day trades are closed in a five-day period and the value of those trades is worth more than 6% of the deposit capital. If the account holder has met this threshold, this will result in a margin call enforced by the broker, meaning they’ll need to deposit more funds.
The guidelines state that during this time, a trader should only be able to close trades. If the individual meets the margin call, they can continue to trade. The minimum equity a pattern day trader must have in their platform is $25,000.
The pattern day trading rule does apply to all securities, not just forex. This includes futures, options, penny stocks, shares, bonds, ETFs, and cryptocurrencies such as Bitcoin.
What Happens If You Pattern Day Trade?
There is no penalty for a pattern day trading violation other than the freezing of a margin account until more funds are deposited. The legislation does not apply to cash accounts. Since the restriction is implemented by the broker, the penalty can vary. The flag is not permanent and does eventually go away. It will often last for 90 days, though if a broker is lenient the timeline can be reduced.
The ban does not apply to institutional stock brokers as it is designed to protect retailer traders. It is not illegal to be a pattern day trader, but those who are flagged as using the strategy must prove they can afford to cover the associated risks. If you are pattern day trading with sufficient capital, when filing your taxes you may find you qualify for Trader Tax Status (TTS).
Examples Of Pattern Day Trading
The pattern day trading rule is simple when explained through examples. Let’s imagine Sarah has opened a margin account with $1000. If she were to short stocks in Apple on Monday and close the trade within trading hours on the same day, this would count as one day trade. Let’s imagine she then goes long on Tuesday and closes the trade shortly after making a profit. If Sarah were to repeat this pattern on Wednesday and Thursday, this would be four day trades in a five day period and a warning would be placed on Sarah’s account.
How To Navigate Pattern Day Trading Rules
The pattern day trading rule was designed to protect retail traders from absorbing risks beyond their means, so looking for loopholes is not advised. But for those who cannot meet the $25000 margin call, here are some tips for how you can navigate the pattern day trading rule.
- Hold positions overnight – The PDT rule only applies to day trades. Therefore, if you hold a position overnight, this would not count towards your four allotted trades.
- Premarket vs after hours – If you close a trade after business hours on the same day, this does not count as a day trade. However, if you open a trade premarket, and then close it that same working day, it does count as a day trade.
- Consider broker training implications – A broker can add a pattern day trading warning notice to an account if they have sufficient reason to believe this is one of your strategies. One common method is by noting any day trading training qualifications with the broker.
- Use a cash account – Pattern day trading is only applicable to margin accounts. If you are trading without margin (using a cash account) you can avoid the rule altogether.
- Sufficient capital – Pattern day trading is legal, however, you must have the capital in your account to show that you can afford to take the risk. If you have $25,000 to trade, you needn’t worry about the rule or how to disable it, just keep your account sufficiently topped up.
Is There A Pattern Day Trading Rule In The UK & Canada?
The pattern day trading rule is only applicable to traders in the USA. It does not apply to those who are trading in the UK, Europe, India, Australia or most other jurisdictions. It may apply to traders in Canada if the broker clears trades through the US securities exchange.
Examples of US brokers that implement pattern day trading rules are Wealthsimple, Vanguard, Chase, Interactive Brokers, Stake, WeBull, Degiro, Schwab and Fidelity.
Final Word On Pattern Day Trading Rules
The pattern day trading rule is designed to protect US traders from losses that can occur when trading on margin. It applies to forex, futures, options and stocks. In fact, it applies to all securities. Fortunately, there are ways you can avoid being lumped with a flag on your account that involve depositing more funds, restricting the volume of trades and closing positions overnight.
FAQ
Does My Broker Allow Pattern Day Trading?
Any US broker that is regulated by FINRA will implement the pattern day trading rule. There is no such rule in Europe, Asia or Australia. This includes brokers such as Questrade, eToro, and Robinhood. It is a legal requirement that they manage PDT on their platform. You can avoid the rule by reducing the volume of day trades you exercise in a given period. You can also speak to your broker about how to disable and avoid pattern day trading warnings on Robinhood, for example.
What Happens If You Pattern Day Trade?
If the pattern day trading recognition software concludes you have met the threshold, you will be asked to deposit more capital into your account. Once you have done this, you can continue to trade as normal. If you do not, you will be restricted to closing trades only.
Does The Pattern Day Trading Apply For Forex?
Yes – the pattern day trading rule applies to forex. In fact, it applies to all securities. This includes stocks, bonds, futures, options, and crypto.
Why Is Pattern Day Trading Bad?
Pattern day trading is not bad per se and is technically not illegal. However, day trading on margin is a risky activity. The rule aims to minimise the losses of traders who cannot afford the risk. It does this by freezing a retail account until they can prove they have sufficient funds to cover any potential losses.
Can I Be A Pattern Day Trader?
If you’re trading outside the US or you have the funds to ensure a minimum of $25,000 in your margin account at any one time, you’re free to day trade as much as you like. If you do not meet these requirements, you may be prevented from day trading.
How Does Pattern Day Trading Work?
A trader is classed as a pattern day trader if they execute a certain number of day trades within a short period. This triggers the broker to add a flag to their account. The trader must then prove they have sufficient funds to cover this strategy by depositing further capital.