A pattern day trader (PDT) is a Financial Industry Regulatory Authority (FINRA) designation for those who make four or more day trades in a margin account over five days when the transactions account for more than six percent of total trading activity for the period.
How do you know if your trading qualifies you as a PDT? If it does, what do you need to do? Are there ways around the rule?
In this post, we’ll answer all these questions and more so that you can avoid PDT violations that may cause your broker to freeze your account.
What Does It Mean to Be a Pattern Day Trader (PDT)?
According to the SEC, a pattern day trader (PDT) is defined as someone “who executes four or more “day trades” within five business days, provided that the number of day trades represents more than six percent of the customer’s total trades in the margin account for that same five business day period.” This definition is helpful but requires a bit of unpacking.
Let’s begin by defining “day trade”.
A day trade occurs when you open and close a position on the same day, which means you either purchase or short a security, and then on the same day, you sell that security or cover (close out the short position on the security). This is simple enough. But this alone does not qualify you as a PDT. You must also meet the second part of the definition – the day trades must make up more than six percent of your trading activity over the five days.
An important note is that this definition is only the minimum requirement. The exact rules for qualifying as a PDT may vary depending on the brokerage firm, and it may be stricter than the above definition. If you think you may be eligible as a PDT, you should look up your broker’s rules.
To better understand the PDT rules, it helps think of traders as falling into two categories. The first category consists of those who consider themselves day traders. Individuals in this group have account values of $25,000 or more, and their brokers know they intend to day trade. The second category has less than $25,000 in their account and accidentally violates the pattern day trader rules.
If you’re in the first category, classification as a PDT is not bad. If you’re in the second category and your broker labels you as a PDT, you violate the rules, which is a bad thing.
How would you accidentally be labeled as a PDT if you’re not a day trader? Let’s look at an example.
Say you have a brokerage account with $10,000 in it. You don’t trade very often, but you’ve recently gotten a bit of extra money, and you decide to use it to buy four different securities. Later that day, you change your mind about the securities and sell them. These would count as day trades since you bought and sold them within the same day, and the transactions may put you in violation of the PDT rules.
As you can see, it’s not hard to become labeled as a pattern day trader, even if you do not consider yourself a day trader and you aren’t day trading regularly.
If you can meet the requirements without being what most people would consider a genuine day trader, why are the rules set up the way they are, and why do they even exist in the first place? The short answer is to limit excessive trading, but the longer answer requires looking at the history of the PDT rules, which we’ll do next.
The term “pattern day trader” was adopted in the 2001 Day-Trading Margin Requirements. Before the adoption of these requirements, the PDT rules did not exist.
The goal of these rules was to curb the level of risky day trading. Compared to many other long-term investments, day trading comes with considerable risk. The SEC wanted to limit the number of traders taking on an inappropriately high level of risk. But creating rules around risk is tricky since an appropriate level depends on many factors (age, income, investment knowledge, experience, etc.). There’s no perfect way to create rules applicable to everyone that appropriately gauges the level of risk a trader can handle.
What the SEC typically does in these instances is to set a financial threshold. Once you have a certain amount of money, it is assumed you are better positioned to take on riskier investments. Only accredited investors, which the SEC defines as those meeting particular net worth requirements, can invest in hedge funds (though in August of 2020, the SEC announced its intention to update the accredited investor definition to take more into account when judging the sophistication of an investor than merely net worth).
This is why the $25,000 account requirement exists. The SEC believes that those with less than $25,000 in an account cannot take on the risks of day trading.
If you have less than $25,000 in your account and trade only occasionally, what happens if you accidentally violate the PDT rules? The good news is that violation of the PDT rule does not lead to jail time or fines, though there are consequences.
If you break the PDT rules, the exact consequences will vary depending on your account’s broker since some brokers have stricter rules than others. The broker may only flag you as a pattern day trader if this is a first-time violation. If this is the case, you’ll want to be especially careful with your trading since your broker will now monitor your account for any more day trading.
What happens when you violate the PDT rules is that you must deposit enough funds to bring your account balance up to $25,000, or the broker will freeze your account for the next ninety days. Typically, you can close any existing positions during this freeze, but you cannot open any positions. Sometimes the broker may wait until a second violation to enact this freeze on your account. A broker may also limit your margin buying power, which would keep you from using margin and would instead require any trades to be made with cash.
Suppose you violated the rules by accident, and your broker suspended your ability to open new positions. It may be worth reaching out to your broker, especially if you have no intention of day trading in the future. The broker may lift the hold on your account if you abide by specific rules or meet certain requirements.
At the beginning of this post, we talked about two categories of traders – those who have over $25,000 and consider themselves day traders and those who have less than $25,000 and accidentally violate the PDT rules. But what if you’re interested in day trading but don’t have $25,000 in your account? The good news is that there are plenty of ways to get around the PDT rule.
Limit Daily Trades
The most apparent option for ensuring you don’t violate the PDT rules while still day trading in accounts with less than $25,000 is simply limiting the number of trades you make in a day. If you never place four or more trades in a day, you won’t violate the rule.
Another simple way around the PDT rules is to make swing trades instead of day trades. As discussed above, a day trade is when you open and close a position on the same day. A swing trade is when you open a position one day and close it another day. While the rules regarding day trades are pretty strict, no similar restrictions exist for swing trades. This means that regardless of the amount in your account, you may place as many swing trades as you’d like.
Another option is to have accounts with different brokers since the four-trade limit is per account, not per person. While this option does allow you to day trade, having the headache of managing multiple accounts can be frustrating.
You may also consider working with a foreign broker since the PDT rules apply only to U.S. accounts, but you should be aware that working with a foreign broker comes with its own set of complications.
Finally, you could consider trading in other markets, such as forex or options, with different requirements.
These options give you ways to get around the PDT rules effectively, but just because you can do something doesn’t mean you should do something. While having a certain amount of equity available does not guarantee you are a more capable trader, the SEC came up with these rules. Day trading can be risky, and regardless of how much capital you have available, you should typically approach day trading with some level of restraint if you are a novice trader.
Day trading is exciting, but it’s also complicated. The PDT rule is just one example of how trading without first conducting sufficient research may have negative consequences for you and your portfolio.