How to Avoid a Pattern Day Trading Designation

Pattern day trading refers to a specific designation within financial markets that impacts how individual investors can trade securities. This regulatory measure, primarily enforced by bodies like the Financial Industry Regulatory Authority (FINRA), aims to manage the risks associated with frequent, high-volume trading. Understanding this designation is important for market participants to navigate trading activities and avoid potential account restrictions.

Understanding Pattern Day Trading Rules

A “pattern day trader” is defined by FINRA Rule 4210. This designation applies to any margin account customer who executes four or more “day trades” within five consecutive business days. These day trades must also represent more than six percent of the customer’s total trading activity in that margin account during the same five-day period.

A “day trade” occurs when an investor opens and closes a position in the same security within the same trading day. This applies to buying and selling, or selling short and buying to cover, the same security. The rules primarily apply to trading in equities and equity options within a margin account.

Pattern day traders must maintain at least $25,000 in equity in their margin account on any day they engage in day trading. This equity, which can be a combination of cash and eligible securities, must be present before any day trading activities commence. If the account equity falls below this $25,000 threshold, the pattern day trader is prohibited from further day trading until the account is restored.

Strategies to Prevent Pattern Day Trading Designation

To avoid being designated as a pattern day trader, investors can implement strategies focused on managing trade frequency and account equity. One method involves limiting day trades within the five-business-day window. Investors can plan trades to not exceed three day trades in any rolling five-day period, often by holding positions overnight.

Maintaining account equity above the $25,000 threshold is another direct way to avoid the restrictions associated with the pattern day trader designation. The $25,000 minimum can consist of a combination of cash and eligible securities held within the margin account. Consistently monitoring the account balance and adding funds if it approaches the minimum can prevent a designation.

Utilizing a cash account rather than a margin account offers an alternative for traders who do not meet the $25,000 equity requirement. The pattern day trading rules do not apply to cash accounts, allowing for an unlimited number of day trades as long as settled funds are used for each transaction. However, cash accounts are subject to “good faith violations” if securities are sold before the funds from their purchase have settled.

The settlement period for most stock transactions is T+1, meaning transactions settle one business day after the trade date. This implies that funds from a sale in a cash account are generally not available for reinvestment until the next business day. Trading in a cash account requires careful management of settled funds to avoid violations and ensure liquidity for new trades.

Navigating a Pattern Day Trading Call

If an investor’s account is flagged as a pattern day trader, the brokerage firm typically provides notification of the designation. This notification often includes details about the account restrictions that will be imposed. The immediate consequence of a pattern day trading designation for accounts under $25,000 is a restriction on further day trading activity.

The most common restriction is a 90-day trading limitation, during which the account can only execute closing transactions or trade on a cash-available basis. To lift this restriction, the investor must deposit sufficient funds to bring the account equity up to or above the $25,000 minimum. This deposit must remain in the account for a specified period, typically two business days, to ensure the funds are fully settled.

Brokerage firms may offer a “one-time” waiver or appeal process for the pattern day trader designation. However, these waivers are generally limited and are not guaranteed. If the account falls below the $25,000 threshold again after a waiver, or if the initial equity call is not met within the stipulated timeframe (typically five business days), the account will likely face a prolonged 90-day restriction. A repeated pattern day trading violation can impact future trading privileges and the relationship with the brokerage firm.