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what is the PDT rule
Let's Talk About The PDT Rule
It is almost impossible to trade in the financial markets, especially as a newbie or first-timer without coming across the term PDT. If you don’t know what PDT means or are yet to wrap your mind around how it works, you no longer have to lose sleep over it because we have got you covered. So make yourself comfortable and tag along. In this case, read along.
First things first, what is Pattern day trader (PDT)?
PDT is short for pattern day traders, and it’s used to describe day traders who execute more than trades in a day within five trading or business days using the same account.
When we say “trading” day, we mean “day trading” days — So, we are talking about a day trader (someone who opens and closes all positions in the market the same day).
The Pattern Day Trading (PDT) rule or the PDT rule was developed and jointly implemented by SEC and FINRA in 2001 to reduce the risks associated with day trading — primarily, overtrading.
Understanding the pattern day trading rule — The PDT rule
If you are trading a margin account whose value is less than $25,000, such trading account is tagged or labeled as a PDT account. This means that you must maintain equity of at least 25,000. Also, you will be restricted to making three-day trades within five days.
If a trader attempts to break the rule by taking more trades after reaching the stipulated limit, you will get a warning notification from your broker, and your account will be frozen for 90 days if you ignore their warning.
In addition to reducing the risks associated with day trading, the PDT rule also gives you more buying power. For a non-day trader, you will get 2:1 buying power, while day traders get up to 4:1 trading power. Think leverage.
Recall that a PDT is expected to maintain 25000 dollars equity at the start of the trading day — nothing short or less (not even $24,5000 equity will suffice to open a trading position.
Thanks to the handsome buying power that the PDT rule offers, if you have 25000 dollars in your trading account, a 4:1, you can control $100,000 in day trading.
While you are at it, you should have it at the back of your mind that the trading power offered by the PDT rule is only applicable to day traders because you won’t be allowed to hold positions overnight.
Regarding the restrictions on the number of trades you can take on a PDT account, cash accounts don’t have such limitations. You can take as many trades as possible until you run out of cash. But there is a catch.
You have to wait for your trades to settle (which takes three days from the day you traded the stock and one day from the trade date for options).
Regulations that govern pattern day traders
At this point, you should already have an idea of what the PDT rule entails. Contrary to popular misconceptions about pattern day traders, they are not limited to stocks alone.
Pattern day traders can trade as many securities as they want, including short sales. However, as we mentioned earlier, if a pattern day trader’s equity (or account value) drops below the stipulated 25,000 dollar mark, he/she will be prohibited from making further day trades until your account balance is brought back up.
If by chance you get a margin call (or warning) from your broker, you have up to five days to respond. During that period, the trading account will be restricted until the call conditions are met. That is, depositing more money into the account to bring the balance back up.
Are there special considerations under the PDT rule?
Speaking of special considerations under the PDT rule, it is important to note that the Pattern Day Trading rule (the PDT rule) is limited to stock and equity options.
Going by the Federal Industry Regulatory Authority (FINRA) stipulations, the PDT rule differs between standard day traders in stocks and equity options regarding the number of trades a trader can hold at any given time.
While both traders under the PDT rule (stocks and equity options) have a set minimum amount of asset that traders must have in their margin account, the amount doesn’t necessarily have to be in cash. Instead, it can be a combination of cash and other eligible securities.
Having a minimum of 25,000 dollars equity in your brokerage account as established by the FINRA (which can be cash or a combination of eligible securities) is intended to reduce the risk of overtrading.
How would you like an illustration of Pattern Day Trading — the PDT rule in action!
To be sure that you grasp completely what the PDT rule is all about, here is an example of pattern day trading rules, The PDT rule in action.
Suppose you have $30,000 worth of assets in your margin day trading account. This means that you are eligible to purchase up to $120,000 (4:1) worth of stocks or equity options compared to the standard $60,000 (2:1) available to an average non-day trader. Thanks to the PDT rule buying power.
If the stocks gain 1% over the day, your PDT account would have gained an estimated $1,200 in profit — which is a stunning 4% increase.
On the other hand, a non-day trader with the same account size or worth of asset will gain only 2% or $500 on a margin account. Thus, you will agree that the margin is wide between PDT account compared to that of an average trader.
While the PDT rule may seem appealing for individuals or traders with high net worth, one must have it at the back of his mind that leverage is a double-edged sword, and it cuts both ways. While it’s capable of making you huge amounts of money or gains on investment, it can also run you aground if you lose focus or get carried away.
How to get around the PDT rule?
Before discuss how traders with shallow pockets or small-sized margin account can get around the PDT rule, let’s take a second to define who FINRA describes as a pattern day trader.
- You must be trading a margin account
- You execute four or more day trades within five business days on a margin account
- Your day’s trades constitute more than 6% of your total trading activity over five days
Once a trader checks all these boxes, his/her margin account will be flagged by the broker and labeled as a pattern day trading account. The PDT rule is almost instantly implemented on such an account to limit their trading activity in the stock market.
Getting around the PDT rule
As a day trader, the last thing you want is someone placing restrictions on your account and preventing you from participating in as many trades as you want. However, for day traders who can’t afford to pump $25000 into their margin account, there are ways to circumvent the PDT rule.
One popular way of getting around the PDT rule is to sign up with offshore brokers. Opting for offshore brokers will save you from the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) rules.
However, you must be careful not to fall for scam companies. So, take it upon yourself to research any offshore broker before signing up with them.
Other ways of getting around the PDT rule include:
- Trading in a cash account
- Trading futures
- Trading options
Trading in a cash account
Trading a cash account is arguably one of the easiest ways of avoids the PDT rule. However, you can only trade with settled funds. What that means is that when you buy or sell stocks on a cash account, you have to wait for two days in addition to the trade date (T+2) before you can use the funds again.
So, if you trade on stocks on Monday, that fund will only be available for use on Thursday. So, in this example, Monday is your trade date. Tuesday and Wednesday are the two waiting days until the funds settle on Thursday.
However, if you have a large account size, say $20,000, you can trade as much as you want you run out of funds.
As you may already know, trading futures entails an agreement to buy or sell an asset in the future at a predetermined date and price. Since the PDT rule doesn’t affect futures, your trading activity is not limited by FINRA rules. As such, you can trade your heart fill on futures with less than $25,000.
Trading options involve an agreement between a seller and buyer that gives the seller the right to either sell or refuse to sell a particular asset at a predetermined date and price.
While day traders who opt for trading cash account will have to wait for a period for their funds to settle, trading options don’t have such restrictions — options trades settle overnight.
For instance, with $10,000 worth of assets in your trading account, you can trade up to three options and have the funds available for trading the following day because they will settle overnight.
There are several options available to day traders to get around the PDT rule and partake in as many trades as they want.
All you have to do is gain adequate knowledge on the available options and make the most of them. The idea is to explore the loopholes in the PDT rule, and you may not be needing an offshore broker after all.
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