Pattern Day Trader Rule
While the pattern day trader (PDT) rules were created with the best of intentions, I find the regulations simply absurd! I honestly believe the regulations do more harm than good to the markets by keeping traders out of the market and limiting liquidity.
The pattern day trader rules were adopted in 2001 to address day trading and margin accounts. The US Securities and Exchange Commission (SEC) rules took effect February 27, 2001 and were based on changes proposed by the New York Stock Exchange (NYSE), the National Association of Securities Dealers (NASD), and the Financial Industry Regulation Authority (FINRA). The changes increased margin requirements for day traders and defined a new term, “pattern day trader.” The rules were an amendment to existing NYSE Rule 431 which had failed to establish margin requirements for day traders.
Why Was It Changed?
The rule was changed because the previous rules were thought to be too loose. Risky traders, at the height of the tech bubble, were day trading without the proper financial backing to cover their high-risk, short-term trades. Day traders were using “cross guarantees” to cover margin requirements in their accounts. These cross guarantees resulted in massive, and often unmet, margin calls in losing accounts. The rule was intended to keep real money in margin accounts for individuals who engage in what is deemed risky, pattern day trading.
Most day trading accounts end the day with no open positions. Since most margin requirements are based on the value of your open positions at the end of the day, the old rules failed to cover risk generated by intraday trading. The pattern day trader rule is meant to provide a cushion for the risk created by intraday trading. Prior to the rule, it was possible for accounts to generate huge losses with no collateral to support the trades. Many traders and capital firms were wiped out as a result of the tech bubble bursting.
What Is A Pattern Day Trader?
The definition of pattern day trader on the FINRA website is any “margin customer that day trades four or more times in five business days, provided the number of day trades is more than six percent of the customer’s total trading activity for that same five-day period.” According to the rule, traders are required to keep a minimum of $25,000 in their accounts and will be denied access to the markets should the balance falls below that level. There are also restrictions on the dollar amount that you can trade each day. If you go over the limit, you will get a margin call that must be met within three to five days. Further, any deposits that you make to cover a margin call have to stay in the account for at least two days.
Can I Day Trade in My Cash Account?
Day trading is usually only allowed in margin accounts because the practice of day trading could violate free-ride trading rules. Stock transactions take three days for settlement. Buying and selling stocks on the same day in a cash account could violate the rule if you are trading with funds that have not yet settled from a former purchase or sale. In other words, the danger lies in using the value of an unsettled trade to engage in another trade. This type of activity will get your account suspended for up to ninety days or more. Margin account requirements are meant to ensure that your account will have the necessary equity to cover your transactions without breaking the free-ride rule.
What if I Break the Pattern Day Trader Rule?
The average investor is allowed three day trades in a five-day rolling period. If you make more than three day trades in that five-day period, then your account will be restricted to only closing trades. If you violate the pattern day trader rule the first time, you will likely just get a warning from your broker although I have heard of some enforcing it on the first violation. If you violate the pattern day trader rule a second time your account can then be suspended from trading for ninety days. It is understandable that the SEC would want to protect the market from risky traders, but the rule does little to actually prevent it. It merely entices would-be day traders to over extend themselves in order to get into the market and then allows them to borrow up to four times the account value with certain brokerage firms that offer leverage.
Wouldn’t it be better if small traders were allowed to trade on a cash-only basis as their accounts permitted? The pattern day trader rule states that an account holder with a value of over $25,000 is deemed “sophisticated.” Therefore, if someone has $24,999 in an account, then they are not sophisticated. So the rule implies that a one dollar difference in account size earns you sophistication. How ridiculous! The SEC intended to help the markets and investors better protect themselves. Last time I checked, this is the United States of America. I find it odd that the government is worried about people losing money in the US Stock Market but, I can go to the any casino and lose my life savings on one roll of the dice. The pattern day trader rules just interfere with free market action.
Do Pattern Day Trader Rules Cover All Types of Trades?
Oddly, the PDT rule only applies to stocks and options. Other tradeable securities are excluded. You can trade as many futures contracts or Forex pairs as you would like. It is also possible to get around the rule by overnight or day-to-day trading, instead of actual intraday trading. A day trade, by definition, is a trade that is opened and closed on the same day. A trade opened in pre-market and closed during normal trading hours, or even after the closing bell, is considered a day trade. If you buy stocks or options three times in one day and close them all on that same day, it is considered three day trades. However, a trade that is opened at the close one day, and closed at open on the next day, does not count as a day trade.
Why Are Pattern Day Trader Rules Bogus?
The PDT rule is bogus for a number of reasons.
- The rule targets small investors and keeps them out of the market. If your account is large enough that four day trades is less than six percent of your total trading volume, then you probably have significantly more than $25,000 in your account. The beginner trader starting out, speculating in the markets, does not have $25,000 in their trade account.
- Once you have been pegged as a pattern day trader by your broker, it is likely that they will maintain that rating. It creates a reasonable belief that you will engage in high-risk day trading until you get above $25,000. After you violate the rule once, the penalties will become more strict.
- The rule interferes with normal market functions. Speculating and shorting the markets are natural and beneficial aspects of market functions. They each add liquidity and help to balance supply and demand. By requiring margin account minimums, the SEC is keeping potential market participants out of the market and limiting liquidity. The worst part of this rule is the restriction to potential short sellers.
- Options are not marginable. You cannot buy an option on margin, so why do you have to maintain margin limits in order to trade them. It is ridiculous. Unfortunately, all US based brokers are required to enforce the pattern day trader rules.
- Why $25,000? I can understand having a margin requirement, but why such an arbitrary number? It only takes $2,000 to open most margin accounts, so why can’t day traders use the same amount? It would much safer for a beginner to test the water with one month’s rather than most of one year’s salary.
- It puts limits on speculative trading that isn’t in the spirit of day trading. As a short-term trader, I tend to make a lot of trades. For the most part, they are open for a couple of hours, days, and sometimes, up to a few weeks. I always trade in cash, but if I have a run of being really right (or wrong) in the market, then I could easily have three or more trades close in the same day. That’s sensible risk management. It certainly doesn’t make me a risky or pattern day trader. Managing risk is one of the foundations of trading. The pattern day trader rule hinders the ability of traders with account sizes under $25,000 to limit risk through quick trades.
Pattern Day Trader Conclusion
Unfortunately, the pattern day trader rules have been in effect since 2001. It doesn’t look like change is coming any time soon. Over the last few years, I have worked with quite a few traders that begin trading with accounts that are significantly smaller than $25,000. I have been able to create five ways to get traders around the pattern day trader rule.
If you are interested in learning my five ways to get around this rule, then you will not want to miss my webinar. I will host a live training webinar on May 2, 2012 to discuss the five techniques that I have learned over the years to get around the pattern day trader rule.
