The pattern day trading rule, or the PDT rule, is perhaps one of the biggest issues new traders must figure out how to deal with.
As beginners learn how to day trade with high hopes they are often discouraged by this rule.
At first glance, it seems just like a way to keep the small traders down, but does it have a purpose?
Let’s look at exactly what the PDT rule is, why it was made, and the best ways to deal with it.
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The pattern day trader rule states that you cannot make four or more round trip day trades within a period of five business days.
A round trip day trade is when you both buy and sell a stock on the same day. So if you buy a stock and wait to sell it the next day then it does not count as a day trade.
The number of day trades also can not make up more than 6% of the margin account's total trading activity during this five-day period.
If you break this rule you will be designated as a pattern day trader.
This rule was approved by the Security Exchange Commission in 2001 and applies to traders who have a margin account with under $25,000 total capital in the account.
The Security Exchange Commission approved this rule because they consider day trading to be a higher risk investment.
Their argument is that this rule has been put into place to protect beginning investors and feel that those with less than $25,000 to trade with are naturally less experienced and may not properly understand risk management.
In their opinion, a trader with at least $25,000 should be able to understand the risks involved and be free to trade as much as they want.
This rule applies to margin accounts as there is more risk when you are trading with borrowed money.
Even with this claim that it is designed to protect beginning traders, there is no doubt that it also hinders their opportunity for growth.
Many people against this rule believe that it can actually increase a day traders' risk as many beginners will be tempted to hold stocks overnight and for longer periods of time.
Others swear it's a way to keep the poor people poor and to let the rich get richer.
Whatever your personal opinion is on the matter, the bottom line is that it is something you have to learn to deal with.
No, pattern day trading is not illegal. You will not get in any trouble with the law for breaking the PDT rule and getting labeled a pattern day trader.
That being said you still do not want to risk breaking this rule as your broker will place restrictions on your account that will hinder your ability to trade.
Some brokers won't even allow you to break the rule—such as Robinhood—, but if you do break it you will receive a 90-day account freeze for violating the rule.
To avoid breaking this rule you will need to make sure to keep track of your day trades or simply find a way around the rule completely.
This is the most obvious answer, but it not possible for most beginner traders.
If you do have the money and you want to take trading seriously then this will save you the hassle of worrying about a limiting your trades.
If your account total falls under the $25,000 you will be given a margin call and a few days to get your total back up to that minimum mark.
In reality, it is best to have more than $25,000 so you have some breathing room without worrying about the margin call at all.
PROS: The PDT rule doesn't apply to you and you can trade without limit.
CONS: You must maintain a $25,000 account balance and most people don't have $25,000 to invest.
If you are fine with not having an unlimited amount of trades and would just like a few more than 3 per week, you could consider opening multiple trading accounts.
The PDT rule applies to each individual account and not all of them together, so if you open two accounts you now have six total round-trip trades in a five day period.
You can open several accounts with different brokers and get three more trades for each account you have with a separate broker.
The downside of this is that you have to split your money between separate accounts.
PROS: This will allow you to increase the number of trades you can make in total before breaking the PDT rule.
CONS: Have to manage multiple accounts, and your capital is split between them.
Using a cash account is perhaps the most common way people deal with the PDT rule.
The PDT rule only applies to margin accounts, and everyone has the option to switch to a cash account.
Having a cash account will provide you with a little more freedom, as you are not limited to a certain number of day trades per week.
Still, having a cash account does not mean you can trade as much as you want.
Cash accounts are limited in a different way.
You don't have to keep track of how many day trades you make, but rather your total available funds.
When you make a trade you have to wait a full business day for the amount of money you traded with to be available to use again.
You are trading with your own money but it takes a day for that trade to completely process and for the funds to appear tradeable in your account again.
For example, we will pretend you have a $500 cash account. If you bought one share of a stock for $1 and sold it at $2 on a Monday, you would now have a $501 cash account.
However, you would only have $499 available to trade with until the traded funds settled on Wednesday.
Using a cash account is preferred as it is easier than learning new ways to trade, or opening more accounts.
PROS: You are not limited to three trades a week, and it will effectively not allow you to break the PDT rule.
CONS: Funds take a full business day to settle after you make a trade so you still do not have an unlimited amount of trades.
Learning how to trade futures will allow you to bypass the PDT rule completely as it does not apply to futures trading.
If you don't mind learning how to trade them, you can make as many trades as you want.
Futures trading involves agreeing on contracts to buy or sell certain securities at a specific price and time in the future.
PROS: You can trade futures as much as you want without worrying about the PDT rule.
CONS: You have no control over future political, natural disaster, or anything that may alter the market. Futures contracts have an expiration date so you can't just hold them forever hoping the prices change.
Foreign brokers are not governed by the PDT rule, as they are mostly outside the laws of the United States.
If you choose to use a foreign broker, the main thing to remember is that you will likely be paying commissions.
The appeal of brokers in the US is that most now offer commission-free trading and are less of a hassle to deal with.
Many foreign brokers will also only allow you to fund your account through a direct wire transfer.
Make sure to find a trusted broker as using foreign brokers can be risky.
PROS: You can trade as many times as you want without having a $25,000 minimum balance.
CONS: You will most likely be paying commissions on your trades, and dealing with offshore accounts can be risky.
Swing trading is when you either buy or sell a stock but do not close the trade that same day.
Swing traders will often hold their positions for several days, weeks, or even longer.
Many traders do not like swing trading because it involves holding stocks through aftermarket hours.
During the aftermarket hours price movement can be erratic and it is a lot harder or impossible to get out of a position.
However, there are many successful traders that both day trade and swing trade.
PROS: As a swing trade is not a day trade, it does not use one of your three weekly trades under the PDT rule.
CONS: There may be more risk as your money is in the market for a longer period of time.
For those who really want to trade without limits, you should know there are other markets besides the stock market.
The Foreign Exchange Market is worth looking into because you can trade currencies and commodities all you want within that market.
Forex brokers allow you to trade with margin without limiting the number of trades you make.
Just remember to do your own research and know the risks before you invest and trade with margin.
PROS: You can make as many trades as you want and you may be able to get more margin than you would in the stock market.
CONS: You will have to learn about a new market, and you will be paying commissions on your trades.
The fact is that the PDT rule is enforced and doesn't seem to be going anywhere. Instead of dwelling on how unfair it may be, it is best to focus your energy on how to deal with it.
Most traders do not have $25,000 to trade with, but they still find a way to trade. There are still many great options for day trading and the PDT rule is not the end of the road.
Above all else, remember to assess your own risk and don't allow you day trading to become gambling. Only invest with an amount you can handle losing.
Good luck and happy trading!
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