The pattern day trading rule is a restriction imposed on retail investors. The law prevents traders from placing a certain number of trades over a short period. Understanding the restriction will help traders avoid legally required margin calls. By the end of this article, we’ll have explained what pattern day trading means, how to navigate the rules and where the restrictions apply.
What Does Pattern Day Trading Mean?
The pattern day trading rule was implemented by the US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) in 2001. The purpose of the rule is to protect day traders from the risks associated with leveraged retail trading accounts. Customers who are day trading must demonstrate they can afford to cover losses when trading on margin.
Pattern Day Trading Rules
The definition of a pattern day trader is when four or more day trades are closed in a five-day period and the value of those trades is worth more than 6% of the deposit capital. If the account holder has met this threshold, this will result in a margin call enforced by the broker, meaning they’ll need to deposit more funds.
The guidelines state that during this time, a trader should only be able to close trades. If the individual meets the margin call, they can continue to trade.
The minimum equity required for a pattern day trader to have in their platform is $25,000.
The pattern day trading rule applies to all securities, including futures, options, penny stocks, shares, bonds, CFDs, ETFs, and cryptocurrencies like Bitcoin.
What Happens If You Pattern Day Trade?
There is no penalty for violating the pattern day trading rule, except for the temporary freezing of a margin account until additional funds are deposited. The law does not apply to cash accounts. As the restriction is imposed by the broker, the penalty may differ. The flag is not permanent and eventually disappears. It usually lasts for 90 days, but a broker may shorten the timeline if they are lenient.
Institutional stock brokers are exempt from the ban since it is intended to safeguard retail traders. Being a pattern day trader is not illegal, but those identified as using the approach must demonstrate their ability to handle the associated risks. If you have enough capital to be a pattern day trader, you may be eligible for Trader Tax Status (TTS) when filing your taxes.
Examples Of Pattern Day Trading
The pattern day trading rule is straightforward when demonstrated with examples. Let’s say Sarah has opened a margin account with $1000. If she shorts Apple stocks on Monday and closes the trade within trading hours on the same day, it is considered one day trade.
Let’s imagine she then goes long on Tuesday and closes the trade shortly after making a profit.
How To Navigate Pattern Day Trading Rules
The pattern day trading rule was designed to protect retail traders from absorbing risks beyond their means, so looking for loopholes is not advised. But for those who cannot meet the $25000 margin call, here are some tips for how you can avoid the pattern day trading rule.
- Hold positions overnight – The PDT rule only applies to day trades. Therefore, if you hold a position overnight, this would not count towards your four allotted trades.
- Premarket vs after hours – If you close a trade after business hours on the same day, this does not count as a day trade. However, if you open a trade premarket, and then close it that same working day, it does count as a day trade.
- Open multiple broker accounts – Brokers should not share information about how many trades you have made with each other. This would most likely contravene data protection laws. Therefore, you can double the number of day trades you can execute by opening a second account using a different broker without receiving a warning. However, downsides include double the commission and minimum deposits.
- Trade outside the US – Pattern day trading is a rule enshrined by FINRA and the SEC.
Therefore, it only applies to US traders using brokers that process trades in America.
This includes Robinhood, Trading 212, eTrade, Coinbase, Questrade, TD Ameritrade and Revolut.
It covers all tradable securities such as cryptocurrency, stocks, bonds and commodities like gold.
One common method is by noting any day trading training qualifications with the broker.
If you are trading without margin (using a cash account) you can avoid the rule altogether.
If you have $25,000 to trade, you needn’t worry about the rule or how to disable it, just keep your account sufficiently topped up.
Is There A Pattern Day Trading Rule In The UK & Canada?
The pattern day trading rule is only applicable to traders in the USA.
It does not apply to those who are trading in the UK, Europe, India, Australia or most other jurisdictions.
It may apply to traders in Canada if the broker clears trades through the US securities exchange.
Examples of US brokers that implement pattern day trading rules are Wealthsimple, Vanguard, Chase, Interactive Brokers, Stake, WeBull, Degiro, Schwab and Fidelity.
Final Word On Pattern Day Trading Rules
The pattern day trading rule is designed to protect US traders from losses that can occur when trading on margin. It applies to forex, futures, options, and stocks. In fact, it applies to all securities. Fortunately, there are ways you can avoid being lumped with a flag on your account that involve depositing more funds, restricting the volume of trades, and closing positions overnight.
FAQ
Does My Broker Allow Pattern Day Trading?
Any US broker that is regulated by FINRA will implement the pattern day trading rule. There is no such rule in Europe, Asia, or Australia. This includes brokers such as Questrade, eToro, and Robinhood. It is a legal requirement that they manage PDT on their platform. You can avoid the rule by reducing the volume of day trades you exercise in a given period. You can also speak to your broker about how to disable and avoid pattern day trading warnings on Robinhood, for example.
What Happens If You Pattern Day Trade?
If the pattern day trading recognition software concludes you have met the threshold, you will be asked to deposit more capital into your account.
Once you have done this, you can continue to trade as normal.
If you do not, you will be restricted to closing trades only.
Does The Pattern Day Trading Apply For Forex?
Yes – the pattern day trading rule applies to forex.
In fact, it applies to all securities.
This includes stocks, bonds, futures, options, and crypto.
Why Is Pattern Day Trading Bad?
Pattern day trading is not bad per se and is technically not illegal.
However, day trading on margin is a risky activity.
The rule aims to minimise the losses of traders who cannot afford the risk.
It does this by freezing a retail account until they can prove they have sufficient funds to cover any potential losses.
Can I Be A Pattern Day Trader?
If you’re trading outside the US or you have the funds to ensure a minimum of $25,000 in your margin account at any one time, you’re free to day trade as much as you like.