The Pattern Day Trading rule affects all Day Traders. So, before we dive into the Pattern Day Trading rule’s complexities, we must know who the rule applies to. In this case, day traders.
So What Classifies as Day Trading?
“Day Trading” can be defined as the act of buying and selling shares of a stock on the same calendar day.
To be a little more specific, entering and exiting a security position within the same day, often using margin or money borrowed from a brokerage to increase leverage. While this sort of leverage can increase profits (potentially), it could also lead to significant losses.
To help protect beginner investors and day traders from such losses, the Financial Industry Regulatory Authority (FINRA) created the Pattern Day Trader rule.
Defining the PDT Rule (What is it?)
The PDT (Pattern Day Trader) rule is a regulation created by the Financial Industry Regulatory Authority (FINRA) in 2001, which applies to stock traders in the United States to minimize the risk associated with the sometimes volatile stock market.
THE PDT RULE APPLIES TO ANY MARGIN ACCOUNT THAT EXECUTES FOUR OR MORE DAY TRADES WITHIN A FIVE BUSINESS DAY PERIOD AND IS FLAGGED AS A PATTERN DAY TRADER.
The rule states that any margin account that executes four or more day trades within any ruling five business day period will be flagged as a pattern day trader.
After 90 calendar days, the flag is removed if there are no additional day trades. Your account and potential earnings will be limited if your account is flagged.
What counts as a day trade?
According to the PDT rule, a day trade is a complete entry and exit of a security within a single trading day.
This is also known as a round trip. It applies to both long and short trades, which counts during the pre and post-market trading periods.
Determining what counts as a day trade is vital. Just remember that matching buy and sell orders counts as one trade.
For example, let’s assume you have an account with zero trades. At the start of the day, you buy 10 shares. Later in the day, you buy another 10 shares, and then you buy 10 more shares. Your account now has 30 total shares.
Later that day, you enter an order to sell those 30 shares.
Although there are three buy orders from earlier (each 10 share order), there is only one exit order. This means there’s only one matching entry and exit order pair. So it is only counted as one day trade.
The opposite is also true. If you buy to open 30 shares and sell them off in three separate orders later in the day, it’s still only one trade since there’s only one buy order.
What happens if I'm flagged?
Once you surpass the allowed number of day trades, your account will be designated as a “Pattern Day Trader.” You must adhere to 3 trades in a 5 day period or run the risk of having their margin account restricted for up to 90 days, and your account status will drop down to a cash account. It is also important to note that there are two main types of accounts one can trade with.
An account that’s flagged as a pattern day trading account and has less than $25,000 in equity will receive a minimum equity call or equity maintenance call.
Equity Maintenance Call
If you execute any more trades while under an equity maintenance call, your account will be restricted to closing transactions only, meaning you will only be able to close existing positions but can’t open any new ones.
The call is removed when either the PDT flag is removed from the account (90 days) or your account equity surpasses $25,000.
A $25,000 EQUITY BALANCE IS CRITICAL TO AVOID BEING FLAGGED.
If you don’t meet the $25,000 requirement, you will not be allowed to day trade consistently. With a margin account but you will be able to trade via cash account.
The PDT rule is designed to minimize the risk associated with day trading. It can be an inconvenience for new traders due to the simple fact that the rule confines new traders to the number of trades they can make, and ultimately the amount of profit they could establish.
If a new day trader could trade at their will while applying sound risk management principles, they could quickly build up a sample size of trades by which to learn from.
However, the PDT rule hinders this process, delaying their ability to build up a proper sample size of trades due to the policy limiting them to 3 trades per 5 days.
The PDT rule is just a part of the game. Instead of seeing it as a hindrance, new day traders can try to see it as an opportunity to really take the time to learn how to be an effective and efficient day trader. The PDT rule can be an opportunity to take the time to find a niche and build up experience and a portfolio.
This is why it is also essential to have a trading strategy ready. Planning your entries and exits, and keeping track of the trades you place. Understanding and following the PDT rule can help you avoid restrictions on your account.
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