Overeager day traders with margin accounts may risk being flagged as a pattern day trader.
Tell us if you’ve seen this common movie trope: a first-time credit cardholder goes on a shopping spree to celebrate the newfound financial privilege. The shopper recklessly buys more than the maximum credit limit on the card, purchasing more than he or she can afford. When a cashier says the card has been declined, the shopper looks stunned, oblivious to the consequences of carefree consumerism. No amount of chipper 80s mall montage can erase the debt garnered from spending too much too quickly.
Characters from the naive shopper trope usually overspend because they are eager to buy, but are not always conscious of how much they are spending. In the stock market., some overzealous traders may also be prone to making financial decisions without considering the risk, especially if they are trading on margin. To protect traders from making similar mistakes, regulators in the U.S. introduced the pattern day trading (PDT) rule.
The National Association of Securities Dealers — the precursor to the Financial Industry Regulatory Authority (FINRA) — proposed the initial PDT rule to the U.S. Securities and Exchange Commission, who approved it by 2001. As electronic trading became more prominent, regulators aimed to protect inexperienced traders from trading capital too frequently that they were unable to repay.
Inexperienced traders who are unfamiliar with the PDT rule may accidentally be flagged by their broker as a pattern day trader, even if they don’t usually do much day trading. With the flood of new retail traders through 2020 and early 2021, being aware of the PDT rule (and how to avoid breaking it) can help traders avoid complications.
WHAT IS THE PDT RULE?
Here’s the pattern day trading rule, according to the Financial Industry Regulatory Authority (FINRA): a firm will issue a margin call and restrict trading for a pattern day trader who executes four or more day trades within five business days. This happens for pattern day traders whose trades are more than six percent of their total trading activity for that same five-day period using a margin account.
Let’s break that down.
A “day trade” happens when a trader buys and sells (or sells short, then buys) the same stock within a single trading day. A day trade may also happen when a trader opens and closes the same options contract in one trading day. Buying and selling a stock over multiple trading days is not considered a day trade. FINRA defines anyone who executes four or more day trades within five business days as a pattern day trader.
The pattern day trading rule only applies to those trading on margin. The rule takes effect when the number of day trades represents more than six percent of the total trades within the margin account for that same five-day period. A pattern day trader must have a minimum equity of $25,000 on any day that the customer day trades.
WHAT HAPPENS AFTER BREAKING THE PDT RULE?
If the account falls below the $25,000 requirement, the pattern day trader will not be permitted to day trade until the account is restored to the $25,000 minimum equity level. If a pattern day trader exceeds the buying limitation, the firm can issue a margin call to the pattern day trader. The pattern day trader will then have, at most, five business days to deposit funds to meet the margin call.
After the margin call, FINRA says the brokerage can restrict the day trading buying power to only two times maintenance margin excess based on the customer’s daily total trading commitment. If the trader does not meet the margin call by the fifth business day, under FINRA regulations the firm may place a 90-day freeze on that trader’s account.
With Score Priority, a trader flagged as a pattern day trader cannot enter any day trades while the account is below the minimum requirements for a day trader. Pattern day traders who would like to continue day trading must submit the Day Trading Agreement. Score Priority offers a one-time forgiveness, where the trader may submit a Change of Strategy to revert to a regular margin account. You can read more about Score Priority’s day trading policies on our website.
HOW CAN TRADERS AVOID THE LABEL OF “PATTERN DAY TRADER?”
Regulators introduced the PDT rule to require certain levels of equity in traders’ accounts to support the risks associated with intraday trading. Investors may consider changing their approach to avoid meeting the conditions of the rule, such as shifting to a swing trading strategy.
Another way to avoid the consequences of the PDT rule is converting to cash accounts, since the rule only applies to margin accounts. With a cash account, traders can avoid margin fees and the PDT rule, and they may have potentially lower risk. However, shifting away from a margin account means a lower buying power due to a lack of leverage and the inability to short stocks.
Day traders can still trade on margin while adhering to the PDT rule. Staying disciplined by predetermining your entries and exits as well as tracking the conditions of your trades can help traders stay within the regulations.
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