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What's The Pattern Day Trading Rule? And How To Avoid Breaking It

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What's The Pattern Day Trading Rule? And How To Avoid Breaking It

You’re not normally a rule-breaker. But violating the pattern day trader rule is easier to do than you might suppose, especially during a time of high market volatility. Don’t let this happen to you. Here’s what you need to know.

First, a hypothetical. Suppose you buy several stocks in your margin account. Minutes or hours later, you change your mind about a few of your purchases, so you sell them. Your “round trip” (buy and sell) trades all took place on the same trading day.

Here’s where you might get dinged: If you execute four or more intraday round trips within five rolling business days and your margin account value is less than $25,000, you’ve inadvertently violated the pattern day trader rule. Now your account is flagged. Oops!

So, what now? You’re in trouble, but what are the consequences? What if you do it again? More importantly, what should you know to avoid crossing this red line in the future? Keep in mind that you don’t have to borrow on margin to violate the pattern day trader rule. It's a good idea to be aware of the basics of margin trading and its rules and risks

There are a few simple but strict rules that define pattern day trading. Let’s go over them.

Round Trip: There And Back Again

A “round trip” simply means opening and closing a security position. Whether you buy or sell to open, when you close the position, you’ve completed a round trip. If you did it within a single trading day, you’ve made a day trade. 

What Exactly Is A Day Trade?

A day trade is what happens when you open and close a security position on the same day.

Let’s break that down:

  • Open and close (round trip). When we say “open and close,” it means buying and selling, or, for short sellers, selling (short) and then buying. This is also called a “round trip.”
  • Security position. Day trading applies to virtually all securities—stocks, bonds, ETFs, and even options (calls and puts).
  • Same day. If you do a round trip on the same day, it’s a day trade. If you hold your security position beyond the close of the trading day, it’s not a day trade.

What Is A Pattern Day Trader?

You are a pattern day trader if you make more than four day trades (as described above) in a rolling five business day period, and those trades make up more than 6% of your account activity within those five days.

There are different types of day traders but we’ll focus on the following two: 

  • Self-identified day traders. This includes folks who are actually day traders, meaning their brokerage is aware that they intend to day trade and they meet the requirement of a $25,000 minimum account value.
  • Pattern day trading violators. These are people who day traded in violation of the rules without meeting the sufficient capital requirement.

Well, I Violated The Pattern Day Trader Rules. What Are The Consequences?

Now what? It depends on your brokerage. For first-time offenders, the consequences might not be so bad, assuming your brokerage has a more forgiving policy. However, you will likely be flagged as a pattern day trader (in the violator sense) just so your broker can watch your activities for any consistent or repeat offenses. So, tread carefully.

If you make four day trades in a rolling five days, some brokerages may subject you to a minimum equity call, meaning you have to deposit enough funds to have a minimum account value of $25,000 (even if you don’t intend to day trade on a regular basis). Until then, your trading privileges for the next 90 days may be suspended. You could be limited to closing out your positions only. And your margin buying power may be suspended, which would limit you to cash transactions. If you make an additional day trade while flagged, you could be restricted from opening new positions.

This is a big hassle, especially if you had no real intention to day trade. If you violated the pattern day trading rules by accident, or if you were tempted to take some profits (or close out losses) within the same day—enough to get flagged in violation—the hassle just isn’t worth the momentary lapse in caution. But if you inadvertently end up flagged as a day trader and don’t intend to day trade going forward, you can contact your broker who may be able to give you some alternatives to avoid trading restrictions. Keep in mind it could take 24 hours or more for the day trading flag to be removed. 

If you do want to officially day trade and apply for a margin account, your buying power could be up to four times your actual account balance. You could inform your broker (saying “yes, I’m a day trader”) or day trade more than three times in five days and get flagged as a pattern day trader. This allows you to day trade as long as you hold a minimum account value of $25,000, and keep your balance above that minimum at all times.

I Have A Little Over $25K. Can I Place Occasional Day Trades?

Before you do that, be sure you really understand your account balance, as there are many things that can affect your trade equity.

  • If you have no open positions, meaning no unrealized gains or losses, then your start-of-day equity is likely to be the same as your previous day’s end-of-day equity.
  • If you have open positions, either unrealized gains or losses, then your opening equity will depend on how your positions are marked-to-market at the beginning of the trading day. (Marked-to-market means the value of your positions if they were to be immediately sold or bought at current market prices.)
  • If you hold positions with unrealized losses, then your losses may reduce your trade equity (think of them as being marked-to-market at any given time).
  • If you’re holding stocks that were bought on margin, then you may need to subtract the amount of maintenance margin from your trade equity, both cash and unrealized returns, to determine how much you actually have. If your account value falls below $25,000, then any pattern day trader activities may constitute a violation.
  • If you trade futures, keep in mind that futures cash or positions do not count towards the $25,000 minimum account value.

The Bottom Line

Getting dinged for breaking the pattern day trader rule is no fun. Of course, you if want to be a more active trader, possibly even do a little day trading on occasion, then you might go ahead and brush up on the rules concerning margin. Otherwise, if you can steer clear of violating the rules, or simply keep your account value well over $25,000, you’ll have less to worry about should you need to execute a short-term trade.

Image by Pexels from Pixabay

 

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