If you’re on your way to becoming a regular day trader, you’ve probably done some research on the subject. Maybe you’ve tried paper trading for practice, and you feel pretty good about your understanding of some of the challenges that come alongside trading with leverage.
Let’s talk about pattern day trading (PDT) rules, though. Understanding the PDT rules can help you avoid complications later on. It's critical that you understand exactly the kind of activity that constitutes a day trade, even if you’re not planning on day trading very often.
Let's go over what you need to know and what to watch out for.
First, what is a day trade?
Day traders open and close a position during the same day to profit off the price changes of a certain financial instrument.
For example, let's say you open a new position of a certain stock at 9 a.m., then close that same position with that same stock at 3 p.m. You would have just completed a day trade. Day traders rarely hold positions overnight. Hence, the term “day trader.”
Day traders use a wide variety of short-term trading strategies to take advantage of small price movements. They sometimes use margin trading to increase their leverage.
Day traders usually try to make money off the market by either buying a security once the value goes up or short selling it if they think the stock will go down. (In other words, they bet against the stock.) Day traders aim to use the market's volatility to their advantage, no matter which way it goes — up or down.
So, what is a pattern day trader?
Sometimes, day traders who use margin (increased leverage) with one account exceed four (or more) day trades in five business days. When that happens, their brokerage firm must mark their account as that of a pattern day trader, provided that the number of day trades represents more than 6% of their total trades in the margin account for that same five-business-day period.
PDT rules come from the Financial Industry Regulatory Authority (FINRA). Under the PDT rules, you must maintain minimum equity of $25,000 in your margin account prior to starting day trading on any given day. If the account falls below the $25,000 requirement, you cannot day trade until you are back at or above the $25,000 minimum.
As long as you have $25,000 or more in cash and eligible securities in your account, you can make as many trades as you want.
Pattern day trading rules & examples
Regulators implemented pattern day trading rules to prevent inexperienced traders from trading with too much leverage. The FINRA rules don't prevent trading — they just help protect traders from being over-leveraged and also attempt to prevent them from incurring large losses. Let's go over the PDT rules and examples to make them crystal clear
What are the PDT rules?
Once you're deemed a pattern day trader, you must maintain minimum equity of $25,000 in your margin account in order to day trade. However, you can also have a combination of cash and eligible securities to make it up to that $25,000.
As soon as your equity falls a penny below $25,000, you’re required to hold off on day trading until your account has sufficient equity.
Brokers usually lock the account as soon as this rule is triggered, but the lockout period varies. It all depends on the broker's exact guidelines.
What about if you're an occasional day trader? You must follow the same margin requirements as non-day traders, meaning you must have a minimum equity of $2,000 to initial buy on margin and meet the Regulation T margin requirement. In other words, you must have 50% of the total purchase amount and must consistently keep at least 25% equity in your margin account. You'll also face penalties if you don't meet the requirements for margin when day trading.
Examples of pattern day trading
Let's take a closer look. Each of these examples constitutes day trades:
Now, let’s take a look at a separate example of how you might become “labeled” as a pattern day trader. Let’s say you open a $10,000 trading account, then:
Since the PDT rules are triggered when you make four or more trades in a five business-day period, in order to not be labeled a Pattern Day Trader, you can’t day trade again until the next Monday. But you can sell existing holdings provided they were not purchased the same day.
What happens if I’m flagged as a PDT?
Once your account gets flagged for triggering the PDT rules, your broker can issue you a margin call if you hold less than the minimum PDT equity requirement. At that point, you have five business days to deposit funds or eligible securities, or otherwise raise your account to meet the call. If the call is not met, you may experience restricted, but not suspended, trading.
And if you don’t meet the margin call after five business days, your broker may place you under a 90-day cash restricted account status until your account meets the $25,000 minimum.
Day trading on margin
Margin plays a significant role in day trading. But what is margin, exactly?
A margin account refers to a brokerage account in which your broker lends you cash to purchase securities.
Financially speaking, leverage is when a small amount of capital is able to control a much more expensive asset or group of assets. When trading and investing, leverage has the ability to magnify your skillset. If you are adept and able to profit while trading, leverage (margin) may help you make profits faster and/or in larger quantities. However, the reverse is also true, and it’s important to understand the risks involved with trading on margin. If you aren’t proficient and you rack up trading losses, you will do so more quickly and in larger amounts.
You should carefully consider whether short-term trading or long-term investing is the right strategy for you. It’s important to discern the pros and cons between a short-term strategy (trading) or a long-term strategy geared toward managing and potentially growing wealth in the markets, often implementing a buy-and-hold approach (investing).
Leverage: A double-edged sword
Although you might think there is great benefit in accessing increased margin with a pattern day trade account, it’s important to understand that you can lose money.
In fact, when you day trade with borrowed funds, you can lose more than your initial investment. A decline in the value of stock purchased may cause your brokerage firm to require additional capital to maintain your position. An absence of an immediate additional capital infusion may cause your broker to liquidate your position. The same can happen with a short stock position and can result in unlimited losses.
Since expenses can pile up quickly, you must monitor and control this expense.
It’s easy to lose track of how many day trades you’ve completed if you don’t fully understand how to count them correctly. If you can’t maintain the minimum equity level of $25,000, you need to pay strict attention to the number of transactions you make.
As always, it’s important to do your research prior to diving into a new investing strategy or trading practice. Make sure you understand how your brokerage helps you manage your trading — for instance, Ally Invest’s platform gives a warning message if you start to make your third day trade.
Whether you’re a savvy trader or paper trading for the first time, take care to continue honing your investing skills and stay in-the-know on all things day trading.