What Is Considered a Day Trade and What Are the Rules?
Unpack the definition of a day trade and understand the critical regulatory framework for active market participation.
Day trading involves rapidly buying and selling financial instruments to capitalize on short-term price movements. This practice is subject to specific regulations designed to manage risk. Understanding these rules is important for anyone considering frequent trading activity.
Defining a Day Trade
A day trade occurs when an individual buys and sells, or sells and then buys, the same security within the same trading day. This applies to various financial instruments, including stocks, options, and exchange-traded funds (ETFs). The position must be opened and closed within the market’s operational hours on a single calendar day. This can involve purchasing a security and then selling it, or short selling a security and then buying it back to cover the position.
For example, if an investor buys 100 shares of a company’s stock at 10:00 AM and sells those same 100 shares at 2:00 PM on the same day, that is considered a day trade. Conversely, if the investor buys shares on Monday and sells them on Tuesday, it is not a day trade because the position was held overnight. Even trades executed during extended or overnight sessions can be considered day trades if they occur within the same trading day as defined by the brokerage.
The Pattern Day Trader Rule
The Financial Industry Regulatory Authority (FINRA) enforces specific regulations for frequent traders, known as the Pattern Day Trader (PDT) rule. An individual is categorized as a “Pattern Day Trader” if they execute four or more day trades within any five consecutive business days, provided these day trades represent more than six percent of the total trades in a margin account during that period. Once a brokerage firm identifies a trader as a Pattern Day Trader, the designation typically remains even if the trading activity decreases.
Pattern Day Traders must maintain a minimum equity of $25,000 in their margin account. This amount can be a combination of cash and eligible securities, and it must be present in the account before engaging in any day-trading activity. If the account’s equity falls below this $25,000 threshold, the Pattern Day Trader is restricted from further day trading until the minimum balance is restored.
Falling below the minimum equity requirement can also lead to a “day-trading margin call.” If a Pattern Day Trader exceeds their day-trading buying power, a firm will issue this call, and the trader typically has up to five business days to deposit the necessary funds. Until the margin call is met, the account’s day-trading buying power is significantly reduced. Failure to meet the margin call by the deadline can result in the account being restricted to trading only on a cash available basis for 90 days, or until the call is satisfied. Any funds deposited to meet this requirement must remain in the account for two business days following the deposit.
Navigating Day Trading Regulations
Understanding the type of brokerage account used is important for day traders, as regulations differ between margin and cash accounts. While the Pattern Day Trader rule primarily applies to margin accounts, cash accounts are not subject to this specific regulation. However, cash accounts have limitations related to settlement periods.
Securities transactions in cash accounts are subject to settlement periods, which dictates when funds from a sale become available for new purchases. As of May 28, 2024, the standard settlement cycle for most U.S. stock transactions is T+1, meaning trades settle one business day after the transaction date. This means that funds from a sale are not immediately available for another trade in a cash account, which can limit trading frequency. Attempting to trade with unsettled funds in a cash account can lead to “good faith violations” and potentially a 90-day restriction on the account.
To avoid being classified as a Pattern Day Trader, one strategy is to limit day trades to three or fewer within any rolling five-business-day period. Another strategy involves using a cash account, as these are exempt from the PDT rule. However, traders using cash accounts must carefully manage their trades to ensure funds have settled before re-using them.
If a trader is flagged as a Pattern Day Trader and falls below the $25,000 equity requirement, they will face restrictions. To lift these restrictions, the account holder must deposit sufficient funds to bring the equity back above the $25,000 minimum. Many brokers also offer a one-time “PDT reset,” which can remove the Pattern Day Trader flag, allowing the trader to resume day trading under the usual three-day trade limit within five business days. This reset is typically a courtesy and is not always guaranteed, and if the account is re-flagged, subsequent resets may not be available.