Does the PDT Rule Apply to Cash Accounts?

Online trading offers various avenues for individuals to participate in financial markets. A common concern for frequent traders is understanding the Pattern Day Trader (PDT) rule. This rule, designed to mitigate certain risks, often leads to questions about its applicability across different account types. This article clarifies whether the PDT rule extends to cash accounts.

Understanding the Pattern Day Trader Rule

The Pattern Day Trader (PDT) rule is a regulatory measure established by the Financial Industry Regulatory Authority (FINRA) through FINRA Rule 4210. Its purpose is to address risks associated with excessive speculative trading in margin accounts. A “day trade” is defined as buying and selling, or selling and buying, the same security within the same trading day, including stocks, options, and ETFs.

An individual is classified as a “pattern day trader” if they execute four or more day trades within any five consecutive business days. These day trades must represent more than 6% of the trader’s total trading activity in their margin account during that period. The rule also requires a pattern day trader to maintain a minimum equity of $25,000 in their margin account at the close of business on any day they engage in day trading.

Cash Accounts and Margin Accounts

A cash account requires investors to pay for all securities purchases in full using only deposited funds. With a cash account, there is no borrowing of funds from the brokerage firm. When securities are sold in a cash account, the proceeds must “settle” before they can be used for new purchases.

The standard settlement cycle for most securities is T+1, meaning transactions settle one business day after the trade date. This means if a security is sold on Monday, funds become available for new purchases on Tuesday. In contrast, a margin account allows investors to borrow money from their brokerage firm to purchase securities, which can amplify both potential gains and losses. Margin accounts come with specific requirements, including minimum equity levels and maintenance margin requirements.

The PDT Rule and Cash Accounts

The Pattern Day Trader (PDT) rule does not apply to cash accounts. This rule, specifically FINRA Rule 4210, is designed to regulate trading activity within margin accounts and is tied to the use of borrowed funds. Since cash accounts do not permit margin, the regulatory concerns the PDT rule addresses are not present.

While the PDT rule does not apply, cash account holders must still adhere to rules regarding settled funds to avoid other types of violations. A common issue in cash accounts is a “Good Faith Violation” (GFV). A GFV occurs when an investor buys securities with unsettled funds and then sells those securities before the initial purchase has fully settled. For example, if funds from a stock sale on Monday are used to buy new stock on Monday, and that new stock is then sold before the original Monday sale proceeds settle on Tuesday, a GFV would occur.

Incurring Good Faith Violations can lead to account restrictions. If an investor receives three Good Faith Violations within a rolling 12-month period, their cash account may be restricted for 90 calendar days. During this restriction, the account holder would only be able to purchase securities with fully settled cash available prior to placing a trade. This is distinct from a PDT restriction.

Navigating Day Trading with a Cash Account

Engaging in day trading activities with a cash account requires careful management due to the inherent limitations, even though the Pattern Day Trader rule does not apply. The primary consideration revolves around settlement cycles, which dictate when funds from a sale become available for new purchases. As of May 28, 2024, the standard settlement cycle for most stocks, bonds, and ETFs in the U.S. markets is T+1, meaning transactions settle one business day after the trade date. Options also typically settle on a T+1 basis for premium payment.

This T+1 settlement cycle means that if you sell a security on Monday, the cash proceeds will settle and become available for a new purchase on Tuesday. Therefore, a day trader using a cash account is limited by their settled cash balance at the beginning of each trading day. To avoid Good Faith Violations, it is crucial to ensure that funds used for new purchases are already settled, or to hold purchased securities until the funds used to buy them have settled.

One strategy to manage trading in a cash account is to meticulously track the settlement status of funds. Investors can avoid violations by purchasing securities only with funds that have already settled from previous sales or by depositing new cash. While federal regulations like the PDT rule do not apply to cash accounts, individual brokerage firms may have their own internal policies or best practices regarding frequent trading or managing Good Faith Violations, which account holders should review.