What is the Pattern Day Trader (PDT) Rule?
Pattern Day Trader (PDT) rule is a designation from the Securities and Exchange Commission (SEC) that is given to traders who make four or more day trades in their margin account over a five business day period.
A day trade is when you purchase or short a security and then sell or cover the same security in the same day.
Essentially, if you have a $5,000 account, you can only make three-day trades in any rolling five-day period. Once your account value is above $25,000, the restriction no longer applies to you.
You usually don’t have to worry about violating this rule by mistake because your broker will notify you. If you ignore their warnings, they will freeze your brokerage account for 90 days.
The Pattern Day Trading rule was implemented back in 2001 as a safety feature to help reduce the risk associated with day trading.
Make sure to check out FINRA’s new update to the Pattern Day Trader rule in this article.
PDT Meaning
Once your account is labeled as a pattern day trader then you have to maintain at least $25,000 in equity in your account. The plus side to this is you will have more buying power available. For non day traders you only get 2:1 buying power but as a day trader you will get 4:1 day trading buying power.
So if you have $25,000 in your account, you will have $100,000 in day trading buying power to trade with for the day.
However, day trading buying power can only be used on day trades as you will not be able to hold positions overnight. Another important point to take note of is your account has to start the day with $25,000 in it.
The account can’t have $24,500 to start the day and then some of your holdings go up bringing your account to over $25,000 to get day trading buying power. It has to start the day with the $25,000 minimum.
If you are in a regular cash account then you can place as many day trades as you would like until your cash is used up. The only catch to this is you have to wait for your trades to settle before you can use that cash again. This takes two days from the trade date for stocks and one day from the trade date for options.
You also won’t have any buying power in your cash account so you won’t be able to use leverage.
History of the Pattern Day Trader Rule
During the dot-com boom of the late 1990s, it seemed like everyone became a day trader. The practice exploded in popularity, with many traders from the era admitting that it was as easy as buying IPOs on the first day, expecting 20% pops in stock prices.
When the new millennium hit, the dot-com bubble popped and those everyday folks who became full-time traders with little education lost their shirts.
Day trading became vilified by politicians and the media, so the SEC and FINRA acted. They instituted the pattern day trader rule in February 2001 under the guise of protecting the investing public.
Example of the Pattern Day Trader Rule
Let’s say John has a $1,000 trading account. On Monday he day trades Apple stock, Tuesday he day trades Tesla, Wednesday he trades Exxon. He’s made his three-day trades, and won’t be able to make another day trade again until Monday.
However, he can only make one day trade on Monday. This is because he’s already made two-day trades within the five-day period (Tuesday, Wednesday, Thursday, Friday, Monday).
If John makes a fourth day trade within the five-day period, his brokerage account will warn him of the consequences. If he ignores them, his account will be frozen for 90 days, as per FINRA rules.
Let’s break this down even further:
Day Trade Example 1
- You start the day with zero shares
- When the market opens, you buy 100 shares of XYZ
- An hour later, you sell those 100 shares of XYZ to close the position
This is ONE day trade.
Day Trade Example 2
- You start the day with 100 shares of XYZ
- You sell 50 shares after the market opens
- You buy 50 more shares an hour later
- At the end of the day you sell your entire position
This is ONE day trade.
Day Trade Example 3
- You start the day with 100 shares of XYZ
- You sell 50 shares after the market opens
- You sell your remainder 50 shares just before market closes
Ways Around the Pattern Day Trader Rule
There are several ways around the pattern day trader rule, and until recently, most of them were not ideal.
Trading in a Cash Account
In a cash account, you can trade each day, but once you run out of cash, you’re buying power is exhausted for the day. The good news is that trades settle overnight, and you can trade again tomorrow! The best way for most beginners to get started is to trade in a cash account and focus on building a track record of consistency.
In a cash account with $3,000. You would be able to effectively buy $3,000 worth of stock each day. That’s $15,000 worth of stock trading per week.
In a margin account with $3,000, you could take 3 trade in 1 day totaling $9,000 in trades. But then you can’t trade again until the following week. For most traders, a cash account is going to be better when you’re under $25k.
Final Thoughts
The PDT is a headache for new traders. If a new day trader was able to day trade at their will and applied proper risk management principles, they can quickly build up a sample size of trades by which to learn from.
With the PDT, it takes so much longer to build a sample size, as you can’t even trade every day.
With that said, the PDT is a fact of life that we must deal with. And on the bright side, the ubiquity of commission-free trading among the large discount brokers has made this rule far more palatable.