How to Get Around the Pattern Day Trading Rule
Learn how to manage or circumvent the financial regulation that restricts frequent market activity. Optimize your trading approach.
Day trading, the practice of buying and selling financial instruments within the same trading day, offers opportunities for short-term gains. This active trading style operates within a framework of regulatory rules designed to manage risk and maintain market stability. In the United States, one significant regulation impacting frequent traders is the Pattern Day Trader (PDT) rule. This article will explore the intricacies of this rule and various approaches traders can employ to navigate their trading activities.
Understanding the Pattern Day Trader Rule
The Pattern Day Trader (PDT) rule is a regulatory designation enforced by the Financial Industry Regulatory Authority (FINRA) that primarily applies to traders using margin accounts. A “day trade” is defined as buying and selling the same security within the same trading day in a margin account, including stocks and options. An individual is designated as a “pattern day trader” if they execute four or more day trades within any five consecutive business days. This designation applies if these day trades represent more than six percent of the total trades in the margin account during that period.
A requirement for pattern day traders is maintaining a minimum equity balance of $25,000 in their margin account on any day they day trade. This equity, which can be cash and eligible securities, must be present before trading. If the account’s equity falls below $25,000, the trader is restricted from day trading until the account is restored. Exceeding day-trading buying power results in a margin call, requiring funds within five business days. Failure to meet this call can lead to restrictions, such as limiting the account to cash-available trading for 90 days.
Strategies for Trading Under the Rule’s Threshold
Traders who do not meet the $25,000 equity requirement for pattern day trading in a margin account can still engage in short-term trading by adjusting their strategies. One method involves limiting day trades within the rolling five-business-day period. By ensuring no more than three day trades occur, individuals avoid being flagged as a pattern day trader and incurring restrictions. This requires careful tracking of trades.
Another approach is to hold positions overnight. A trade is only considered a day trade if both opening and closing transactions occur on the same trading day. By purchasing a security on one day and selling it the next day or later, the transaction avoids being classified as a day trade. While this strategy bypasses the PDT rule, it introduces overnight risk due to potential price fluctuations and ties up capital longer.
Swing trading represents a broader strategy that aligns with avoiding the PDT rule. This involves holding positions for several days or weeks, aiming to profit from price swings over a medium-term horizon. Since swing trades involve holding securities for more than one day, they are not categorized as day trades. This method allows for active market participation without the constraints imposed by the PDT rule.
Alternative Account Structures
Beyond adjusting trading frequency, individuals can explore alternative brokerage account structures not subject to the Pattern Day Trader rule. Cash accounts offer an advantage, as they are exempt from PDT regulations. In a cash account, traders can execute an unlimited number of day trades, provided they use only fully settled funds for each transaction.
The operational difference lies in the settlement cycle for funds. For most stock trades, funds settle on a T+1 basis, meaning cash from a sale is available for new purchases one business day after the trade date. Buying a security with unsettled funds and selling it before those funds settle results in a “good faith violation.” Three good faith violations within 12 months can lead to a 90-day restriction, limiting the account to buying with sufficient settled cash. Therefore, while cash accounts offer flexibility from the PDT rule, careful management of settled funds is necessary to avoid these violations.
Some traders also consider offshore brokerage accounts, as certain brokers outside of U.S. jurisdiction may not be bound by FINRA’s PDT rule. This option can provide more trading freedom. However, engaging with offshore brokers introduces complexities such as differing regulatory oversight, potential tax implications, and challenges with fund transfers or legal recourse. This path is more involved for the typical U.S. retail investor and requires thorough due diligence due to these risks.
Operating Above the Rule’s Threshold
The most direct way to avoid the Pattern Day Trader rule’s constraints is to maintain an account equity balance at or above the required threshold. By consistently having $25,000 or more in a margin account, a trader can execute an unrestricted number of day trades. This capital level provides the flexibility to engage in frequent intraday trading strategies.
It is important to not only reach but also continuously maintain this minimum equity level. If the account balance drops below $25,000, the pattern day trader designation and its restrictions can be reinstated. Funds deposited to meet a day-trading minimum equity requirement or a margin call must remain in the account for at least two business days following the deposit. Increasing trading capital through saving or investment growth can help achieve freedom from PDT rule limitations.