Pattern Day Trader: Definition, Rules, How to Remove Status & Guide

pattern day trader
Image source: Warrior Trading

A “pattern day trader” is defined by FINRA guidelines as any client who performs four or more “day trades” within five business days, provided that the number of day trades constitutes more than 6% of the customer’s total trades in the margin account during the same five-day period.  Here’s all you need to know about the pattern day trader rule and how you can remove the status from your account.

What Is a Pattern Day Trader?

A pattern day trader (PDT) is a regulatory classification for traders or investors that use a margin account to conduct four or more day transactions in five business days. During that five-business-day period, the number of day trades must exceed 6% of overall trade activity in the margin account.

If this occurs, the trader’s account will be flagged by their broker as a PDT. The PDT classification restricts further trading; this designation was meant to dissuade investors from trading excessively.

Understanding A Pattern Day Trader

Pattern day traders may trade many securities, such as stock options and short sells. This classification will account for any form of exchange as long as it occurs on the same day.

Pattern day traders can trade quantities up to their day-trading purchasing power. This is usually four times the amount of equity they have in excess of their maintenance margin, or the minimum amount of equity that traders must have in their margin account. Those who do not have the PDT designation can only trade up to two times their extra equity.

If a margin call is issued, the pattern day trader will have five working days to respond. Until the call is met, their trading will be limited to two times the maintenance margin excess. Failure to fix this issue within five business days may result in a 90-day cash-restricted account status, or until the issues are rectified.

Long and short positions held overnight but sold prior to new purchases of the same security the following day are excluded from the PDT classification.

 Stock and equity option trades are the only types of pattern day trading.

Pattern Day Trading Example

Consider the situation of a pattern day trader with $100,000 in margin assets. The typical requirements for margin accounts include that she must hold at least 25% of the assets, or $25,000, in order to open one. If the trader’s equity is $30,000 instead, she will have $5,000 more than her maintenance margin.

She could be eligible to buy up to four times her maintenance margin excess, or $20,000 in stock, as a pattern day trader. This is twice as much as the usual margin account customer with the same balance and equity could trade, which is normally two times maintenance margin excess, or $10,000.

With the ability to make larger transactions comes the potential for higher gains, which can make pattern day trading appear enticing to high-net-worth individuals (HNWIs). However, as with any procedures with the potential for bigger profits, the possibility for significant losses is also higher.

What is the Pattern Day Trader Rule?

The Securities and Exchange Commission’s (SEC) Pattern Day Trader (PDT) regulation is a label given to traders who make four or more day trades in their margin account in a five-business-day period.

A day trade occurs when you buy or sell a security and subsequently sell or cover the same security on the same day.

In essence, if you have a $5,000 account, you can only make three-day trades in each five-day rolling period. The restriction no longer applies to you if your account value exceeds $25,000 USD.

 You normally don’t have to worry about accidentally breaking this guideline because your broker will tell you. If you ignore their warnings, your brokerage account will be frozen for 90 days.

The Pattern Day Trading regulation was adopted in 2001 as a precautionary measure to help limit the risk of day trading.

History of The Pattern Day Trader Rule

During the late 1990s dot-com boom, it seemed like everyone became a day trader. The method became quite popular, with many traders of the time stating that it was as simple as buying IPOs on the first day and expecting a 20% increase in stock prices.

When the new century arrived, the dot-com bubble burst, and ordinary people who had become full-time traders with no education lost their shirts.

 As politicians and the media demonized day trading, the SEC and FINRA took action. Under the pretense of protecting the investing public, they implemented the pattern day trader rule in February 2001. 

Pattern Day Trader Rule Example

Consider John’s $1,000 trading account. He day trades Apple stock on Monday, Tesla stock on Tuesday, and Exxon shares on Wednesday. He’s completed his three-day trades and won’t be able to make another until Monday.

He can, however, only make one day trade on Monday. This is due to the fact that he has previously completed two two-day deals inside the five-day period (Tuesday, Wednesday, Thursday, Friday, and Monday).

 If John makes a fourth day trade inside the five-day timeframe, his brokerage account will notify him. If he disregards them, his account will be frozen for 90 days, according to FINRA guidelines.

Alternatives to the Pattern Day Trader Rule

There are various ways to get around the pattern day trader rule, and most of them were not optimal until lately.

Open Several Brokerage Accounts

This is the most logical option. Since the biggest US brokerage firms abolished commissions, even the most inexperienced traders can open multiple accounts. Previously, traders with $1,000 or $2,000 had difficulty implementing this technique.

Those $5 commissions severely ate into profits when you stretched an already modest account so thin.

Since commissions have been eliminated, you can open multiple $100 accounts with the big brokers. As an example:

TD Ameritrade Fidelity E-Trade Schwab

Each additional account provides you with an additional three-day trader per rolling five-day period.

Join a Private Trading Firm

This strategy is better suited to traders with limited capital who want to get serious about trading. Prop firms come in a variety of shapes and sizes, each with its own set of benefits.

Prop firms are classified into three types:

Leverage Stores: These companies are essentially glorified brokers who provide you greater leverage. They frequently charge for software and data while providing little, if any, education.

Mentor-based Firms: These firms often want individuals with some trading experience and a track record, but more importantly, they seek individuals who are passionate about trading and eager to learn. Most do not require deposits, but will expect you to do without much in the way of compensation or income during your training, so you must have savings or other income.

Professional Firms: The firms mentioned above are all professional, but these are on another level. Most offer a salary as well as a profit split, although they normally only hire people with advanced degrees in fields such as math or quantitative sciences. Jane Street Capital is one of these companies.

How to Remove Pattern Day Trader Status From Your Account

 If you have less than $25,000 in your brokerage account, frequent trading can result in your account being shut out. And this can cost you money in a variety of ways. This, however, does not result from making a large number of deals in a short period of time. The regulations are very detailed.

So let’s start with the fundamentals. The Financial Industry Regulatory Authority (FINRA) has established a rather strict criteria for what constitutes pattern day trading. The most straightforward explanation is that it executes four or more “day trades” within five working days.

A day trade occurs when someone buys and sells (or sells and then re-buys) the same security during the same trading session. In some circumstances, there are additional criteria. However, this is the most prevalent reason investors are identified as pattern day traders.

Being dubbed a pattern day trader isn’t a bad thing… if you can afford it. And we’re not only talking about the dangers of day trading. As previously stated, most day traders require at least $25,000 in equity to remain active.

If you fall short of this magic figure, you will be locked out of your trading account for 90 days. And for busy traders, that’s equivalent to being ordered to go three months without eating. If you don’t have enough money to raise your account to the required amount, some brokerages offer ways to get rid of pattern day trader status. In rare circumstances, this can save a failing account.

The Low-Cost Path to Day Trader Status

Those with cash-only accounts can generally day trade to their hearts’ delight. Just double-check with your broker. However, because cash exchanges hands for many days after a stock transaction, this might slow down the trading process. So, unless there’s a focus on penny stocks or a tiny number of shares, it’s unlikely that someone with less than $25,000 in their cash account will be dubbed a day trader. But it is possible.

There are many new investors that open their Robinhood accounts on an hourly basis. Even if they only have a few thousand dollars to trade with, they can quickly reach the pattern day trade level. The elation of rapid winners is contagious.

Assume our young investor purchases an option contract for $125 on Monday morning and sells it for $175 that afternoon. He will repeat the process on Tuesday. This time things don’t go as well. His $125 contract loses $50 in value, so he cashes out to keep his money. However, the funds in his account are burning a hole in his pocket. He discovers a $100 options contract for a company immediately before its earnings call on Wednesday. The corporation outperforms expectations. The contract doubles in value before the end of the day, and our trader cashes out confidently.

Our trader has his sights set on another rather cheap options contract shortly before the company’s earnings call on Thursday. He spends $100 on a contact. And it doubles again by the end of the day. Despite the one loss, our young trader is feeling very confident, and his pockets have gotten a little larger. But, whether he realizes it or not, he’s reached a tipping point.

When Is It Possible to Remove Pattern Day Trader Status?

Our confident trader had achieved pattern day trader level by Friday. But, even before the markets open, he’s placed an order for a short-term options bet. The contract is acquired when the markets open. However, as the price falls, our young dealer is unable to sell it. He no longer has the ability to make day trades. His options contract will become worthless in a few of days. And he’s stuck on the sidelines, watching it degrade.

Like many brokerages, Robinhood begins members with margin accounts. This is almost always a positive thing. When done correctly, margin trading can swiftly rocket an account ahead. Furthermore, it significantly accelerates the money transfer process. However, with margin comes responsibility.

Downgrading his account is the best thing our novice trader can do to save his deal before it expires worthless. He’ll be able to solve his falling options contract as soon as all of the money in his account clears by transferring from a Robinhood Instant Account to a Robinhood Cash Account. And, maybe, he’ll be able to sell that contract before it becomes worthless, leaving him with enough cash in his account to trade with another day.

Pattern Day Trader Interactive Brokers

Because Interactive Brokers (IBKR) caters to professional traders, it should come as no surprise that the company allows day trading. If you do decide to day trade at Interactive Brokers, you must follow the same rules as other American brokers. Here are the specifics:

Pattern Day-Trading Regulations of FINRA

If you’re day trading with an Interactive Brokers account headquartered in the United States, you must observe FINRA’s short-term trading standards. This includes avoiding the following offenses:

More than three securities trades in a 5-business-day timeframe.

Having day trades that account for more than 6% of the account’s trading activity.

If you break either of the preceding restrictions, you must deposit $25,000 into your account. You can trade with this money as long as your account equity remains over that threshold.

Is Pattern Day Trading Illegal?

If the value of your account falls below $25,000, any pattern day trader activity may be considered a violation. Remember that futures cash or positions do not count against the $25,000 minimum account value if you trade futures.

Do Pattern Day Traders Make Money?

According to studies, more than 97% of day traders lose money over time, and less than 1% of day traders are profitable.

How Much Money Do I Need to Pattern Day Trade?

Customers identified as “pattern day traders” by their brokerage firms must have at least $25,000 in their accounts and can only trade in margin accounts, according to FINRA rules.

How Long Will I Be a Pattern Day Trader?

If you place your fourth day trade during the 5-day trading window, your brokerage account will be tagged for pattern day trading for 90 days. This implies you won’t be able to make any day trades for 90 days unless your portfolio value (excluding any crypto investments) exceeds $25,000.

Does Pattern Day Trading Apply To Forex?

No, because the currency market runs very differently than the stock market.

In Conclusion

Pattern day traders (PDTs) are those who make four or more day trades in a five-business-day period utilizing their margin account. If your brokerage business identifies you as a PDT based on your trading activity, you must meet extra restrictions, such as keeping at least $25,000 in equity in your margin account. If a PDT’s account equity falls below this level, their broker may bar them from trading until the minimum balance is restored.

  1. DIAMOND PATTERN: Understanding the Diamond Chart Pattern(+Quick Guide)
  2. Stock Trading Business: How to Start a Stock Trading Business
  3. TRADING ON MARGIN: What It Means and Examples
  4. HOW TO BECOME A DAY TRADER: Step-by-Step Guide

References

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