Pattern day trading is more a designation than a style of investing. And the Financial Industry Regulatory Authority (FINRA) gets to decide who is and isn’t qualified to do so.
At its root, pattern day trading is defined as the engagement of four or more “day trades” within five business days. And those day trades have to represent more than 6% of a trader’s total trade activity in their margin account over that same five-day period.
To help unpack this, let’s first define what a “day trade” is. A day trade is when someone buys and sells (or sells and buys) the same security in their margin account on the same day. This applies to folks trading any type of security. And that includes options.
As for the 6% rule, let’s say someone has $5,000 in their margin account. If they make four day trades on consecutive days equaling a mere $300 (6% of $5,000), they can be designated a pattern day trader. So, it’s easy to see how the 6% rule can quickly come into play. It’s also worth mentioning that these are the bare minimum of requirements. Different brokerages can also set their own bar as to what qualifies as pattern day trading.
What It Means to Engage in Pattern Day Trading
On the surface, there’s absolutely nothing wrong with developing a pattern of day trading. Lots of investors do it. But in order to be granted the right to do so, they have to face additional scrutiny and limitations imparted by regulatory bodies.
For starters, pattern day traders are required to have at least $25,000 (that can be a mixture of cash and securities) in their margin accounts. If the balance falls below $25,000, they can be barred from making additional trades. And that can be a costly penalty for those prone to getting in and out of trades rapidly.
On top of this, pattern day traders are allowed to trade up to four times the maintenance margin excess in their account. This is qualified as the margin excess total as of the close of business the previous day. If that day-trading buying power limit is surpassed, the brokerage can (and usually will) issue what is called a day-trading margin call.
A day-trading margin call is issued in order for the brokerage to cover the deficiency in margin and return the funds in the account to the minimum. When this happens, the person engaging in pattern day trading has five business days to deposit funds to meet the margin call. Until this requirement is met, the account’s buying power can and will be restricted.
If five days go by without meeting the margin call, the pattern day trader’s account can be limited to trading only on a cash available basis for 90 days or outright frozen. But this brings up an important distinction between margin accounts and cash accounts.
Getting Around the PDT Rules
There are a few ways to get around the pattern day trading rules. One extremely risky way is to trade using an unregulated offshore account. Capital Markets Elite Group is one such example. These brokerages aren’t subject to all SEC and FINRA regulations. But this can also mean that your money isn’t protected by any regulatory body. On top of that, this means operating in legal gray area… At least tax-wise. Neither of these are good ideas for folks that take their money seriously.
Another way to circumnavigate the pattern day trading rules is by using an alternative brokerage. One example is Unstocktrade. This is a peer-to-peer brokerage that allows unlimited trades in a cash account. That being said, the trading opportunities are limited compared to standard brokerages like TD Ameritrade or Charles Schwab.
The other way to get around the pattern day trading rules is to simply skip the margin and stick to a cash account. Someone with a strictly cash account can buy and sell as they please using the money they have available. But when they make a trade, cash doesn’t change hands immediately.
When a security is sold it can take as long as three days for the money to settle in a cash account. That means that any profit netted from a quick trade can’t be put to use for multiple days. But keep in mind, this is all at the discretion of the brokerage you use. Each one can have slightly different rules and permissions when it comes to pattern day trading. So read the fine print!
The Bottom Line on Pattern Day Trading
Pattern day trading comes with a fair amount of regulations. It also comes with a good amount of risk. Even if you manage to stay in the good graces of your brokerage, it takes a lot of practice to learn how to day trade successfully. And doing so unsuccessfully can lead to an empty bank account in a hurry.
That’s why it’s best to start by paper trading or using a stock trading simulator. This allows potential pattern day traders to test their strategies without the risk of losing their shirt. But if you’re ready to get started now, you need not go it alone…
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