If you’re interested in trying to day trade, you’ve undoubtedly heard about the pattern day trader, or PDT, rule. Common questions beginner traders ask on social forums, such as Reddit, include: “What is the PDT rule? And how do I avoid the rule so I can trade more each day?” Let’s check out the PDT rule below and discuss popular ways for new traders to deal with it. Spoiler alert: open a cash account!
But first it’s important to know where this rule is actually located. The PDT rule is governed by the Financial Industry Regulatory Authority, or FINRA, which is a not-for-profit organization authorized by Congress to oversee U.S. brokers, ensure market integrity, and protect investors. The PDT rule is adopted in FINRA Rule 4210 addressing margin requirements. While that rule is fairly lengthy, we’ll go through some of the pertinent elements below.
- What does it Mean to Day Trade?
- What is the Pattern Day Trader (PDT) Rule?
- What is the Purpose of the PDT Rule?
- Possible Ways to Avoid the PDT Rule
What does it Mean to Day Trade?
FINRA Rule 4210 defines day trading as the “purchasing and selling or the selling and purchasing of the same security on the same day in a margin account.” Basically that means if you buy and sell a stock in the same day (a so-called “round trip”), or go short and then cover in the same day, you have day traded. The definition applies to options and not futures, but as a new day trader we’ll assume you are looking to begin with buying and selling standard stock tickers on the U.S. exchanges.
Also note that the definition applies to “margin” accounts. What is margin? Think of margin as a loan from your broker. Rules surrounding margin are complicated, but the “loan” provided by your brokerage allows you to buy more stock than you would be able to normally with just the cash you deposited into your trading account. For example, TD Ameritrade provides for 50% margin on a new account with an initial deposit of at least $2,000. That means if you purchase 1000 shares of a $4 stock, you could invest $2000 of your own funds and $2000 borrowed from margin for a total of $4000. Margin can magnify both gains and losses, and result in interest payments and margin calls. As previously stated, margin is a complicated subject and every trader has to individually decide if margin trading is right for them.
What is the Pattern Day Trader (PDT) Rule?
The term “pattern day trader” is actually adopted in FINRA Rule 4210 governing margin requirements. FINRA Rule 4210 defines a pattern day trader as any customer who executes four or more day trades within five business days:
You should explore the definition in the rule on the FINRA website, but for our purposes, the PDT rule limits a new trader with a small margin account to three (3) day trades per week. What is considered a small account? That number is also set out in FINRA Rule 4210 as $25,000. So long as your account remains below that threshold, you are limited to three trades per week.
Let’s consider some examples and see how the PDT rule would apply in practice.
- You day trade once each day on Monday, Wednesday, and Friday after opening your small account. You wouldn’t be able to trade again until the following Monday. If you do trade that day, you would have to wait until Wednesday to make another trade, and so on.
- You open your account and decide to day trade twice on Tuesday. You could trade once more through the following Wednesday to Monday. If you wait until the following Tuesday, you could place three day trades that day if you choose.
- You open your account and make three day trades on Monday. You would need to wait until the following Monday to day trade again.
As noted in the photo below, many brokers provide a count or tally of the number of day trades you have available on the dashboard of the trading platform. As you might have guessed, there are rules that kick in if you exceed the three trade maximum, but most small traders should be aware that their account could be suspended for 90 days. Some brokers like TD Ameritrade allow for a one time exception for new traders since they may be unfamiliar with the PDT rule.
What is the Purpose of the PDT Rule?
Much of what’s been written about the PDT rule on the internet will tell you that it was implemented to protect traders from losing all of their funds too quickly. But that’s only partially true – it was also put into place to protect the brokers themselves. The rule was first proposed in the winter of 1999/2000 by the NYSE and NASDAQ (around the height of the dot com bubble). As explained in the March 2001 final rule promulgated by S.E.C., there was significant concern about the risk of loss associated with trading:
But there was also significant concern about margin accounts, which can magnify both gains and losses, as mentioned above. After all, it’s a real problem for brokers if individual traders go broke and can’t pay back money loaned via margin. As the March 2001 rule explains:
Possible Ways to Avoid the PDT Rule
We’ll cover a few of the ways traders on the web recommend for dealing with the PDT rule. While I don’t have experience with all these methods, we’ll start with a common option which I have used: the cash account.
Open a Cash Account
Perhaps the most popular way for new account holders with less than $25,000 to avoid the PDT rule is to use a cash account. You will often see this recommendation on internet forums. Recall that the definition of “day trading” in Rule 4210 applies to margin accounts. By that definition, the pattern day trader rule doesn’t apply to a cash account where you trade with your own money and not money loaned through margin. So while brokers are concerned about losing money they lend to you, they are less concerned about you losing your own money if you choose.
A cash account does seem like the best option to allow you to trade as often as you choose so long as you have money in your account. But not so fast! You have to become familiar with another term called the “T+2” settlement period. When you click the buttons on your day trading dashboard to buy and sell a stock, a number of things happen behind the scenes for your trade to be final. The time it takes for a trade to be final is called the settlement period. The term T+2 means “trade date plus two days.” As a practical matter, what that means for you is that money used in your cash account to day trade will not be available again for two days. The good news is that you can develop a trading plan to allow you to trade every day. Let’s run through some examples:
- You open your cash account with $5,000. You day trade up to $2,000 on Monday and gain $100. You will be left with $3,000 to trade on Tuesday (remaining “buying power”). On Wednesday you can trade $2,100 and any money you did not trade on Tuesday. In this example, your trades from Monday settled on Wednesday (T+2 date).
- You open your cash account with $5,000. You day trade $2,000 on Monday and lose $500. You day trade $2,000 again on Tuesday and lose another $500. On Wednesday your buying power would be $1,500 plus the remaining $1,000 you did not trade on Tuesday. The funds remaining from your Tuesday trades ($1,500) would be available Thursday.
Hopefully these examples will give you a sense of how trades are accounted for in a cash account. A simple way to think about it is that you can trade about half of the available funds in your account and the T+2 settlement period will allow you to trade each day. But keep in mind that if you lose money, the available funds or buying power will decrease.
So how are you supposed to keep track of your buying power? Fortunately, brokers will often do that for you on the dashboard of your trading platform. For example, the image below show’s TD Ameritrade Think or Swim platform. You can see the available buying power in the upper left-hand corner of the trading screen.
Lastly, when you open your brokerage account it may not be immediately obvious how you open a cash account. The online forms and application may steer you toward opening a margin account. But not to worry. You should be able to call your broker and have them change it over later. For example, I opened a margin account with TD Ameritrade and traded under the PDT rule for a few weeks while learning the platform. I then placed a phone call and asked to switch to a cash account. It was a very easy process.
Open Multiple Brokerage Accounts
Another way discussed on the internet to avoid the PDT rule is to open more than one margin trading account. As discussed, brokers are concerned about their money – not necessarily yours or that of another broker. In general, a broker is not keeping track of day trades you make on another broker’s platform. As a result, you could open two margin trading accounts and make up to 6 day trades per week (3 in each account) without running afoul of the PDT rule.
There is nothing wrong with opening more than one trading account. I previously opened small accounts with both E-Trade and TD Ameritrade. It was a good way to test drive the software and features of each trading platform. A side benefit was that I increased my number of day trades per week.
But you have to decide whether you want to deal with the inconvenience of multiple brokerages. The more accounts you have, the more paperwork and passwords you have to keep up with, and the more trading software you have to learn. Another issue is that you will necessarily have to spread your funds across the different accounts. With your funds spread thin, it may take longer for you to build up your account. However, if none of these issues pose a problem for you, multiple accounts may be a viable option.
Open an Offshore Account
Another way new U.S. traders look to avoid the PDT rule is by opening an account with a non-U.S. brokerage, commonly referred to as an offshore account. I have not pursued this route myself so I cannot make any specific comments on the pros and cons of these accounts.
But the question does come up on internet forums and a large number of commenters seem to view offshore day trading accounts negatively. You can research it yourself but you’ll likely find that the pricing structures are hard to understand and the fees associated with transferring money are not always clear. In addition, some of these brokerages will not accept U.S.-based customers. You can also research the history of failed offshore brokerages, like SureTrader, and decide whether this is something worth pursuing. Considering the risk and uncertainty involved, it may not be worth the hassle when you could open a cash account rather easily.
Grin and Bear It
Finally, you could simply decide to start trading in a margin account and limit yourself to three day trades per week until you reach the $25,000 account threshold. This approach is beneficial in several ways. Day trading is not easy. You’ve probably read that the vast majority of day traders fail. Given the bleak statistics, it would be wise to take things slowly. By limiting your trading you’ll hopefully preserve your capital longer and give yourself time to learn about the market. One of your best trading strategies will simply be “screen time.” Trading requires significant time in front of the computer screen observing the market and gaining experience. Fortunately you can do that every day without placing any trades.
New day traders are always eager to dive into the stock market and begin trading. The markets and the S.E.C. recognized this and the PDT rule was born. Despite its limitations, there are ways of dealing with the rule. Opening a cash account seems to be the most oft recommended way for traders to get started. It’s a relatively simple alternative and avoids the hassles of opening multiple accounts or looking into offshore accounts. There’s also nothing wrong with taking your time as a new trader and limiting yourself to three trades per week under the PDT rule until you can grow your account. Of course, ultimately you have to choose what’s right for you.