What is a “Pattern Day Trader” And How to Avoid Being Classified As One

By February 13, 2017featured, Trader Tips

Every trader shudders when he hears the words ‘Pattern Day Trader’ (PDT). Though this rule was introduced by the Financial Industry Regulatory Authority, Inc. (FINRA) to supposedly safeguard the interests of the trading community, many traders who are just starting out and have smaller accounts are the most affected.  Many see the PDT rules as a major barrier to entry and many more go a few steps further and consider the rule a horrific stifling of trader activity in an otherwise free society, courtesy of the same nanny society that likes to regulate how big your soda can be, whether your children can eat ranch dressing with their school lunch, how muddy your vehicle can be or whether or not you can legally sell your daughter’s Girl Scout cookies in front of your home.

What is a ‘Pattern Day Trader’ And How to Avoid Being Classified As One

Now, without proper guidance about the rules (the pattern day trading rules, not the Girl Scout cookie rule) and how to avoid being classified as a Pattern Day Trader., Many traders let go of profitable trading opportunities to avoid getting caught in this hoopla.  You don’t have to.

In order to help the small traders, we have asked our experts to touch on all aspects of a Pattern Day Trader.  So, in a show of solidarity, go get yourself an extra large fountain soda (especially if you live in New York), retreat to your “safe space” and read on.

In this article, we’ll throw light at the things that can label you as a pattern day trader, the rules that are applied to a PDT account and how you can trade around the rules without being classified as a PDT.

Download a PDF version for this post.

Let’s first define day trading

If a trader buys and sells a security in the same day or sells short and then buys to cover the position on the same day, the trades are considered to be a day trade.

Example 1 of a long day trade: If you buy 100 shares of Apple at 09:35 AM and sell the same by 12:10 PM, it is a day trade.

Example 2 of a long day trade: If you buy 100 shares of Apple at 10:20 AM and sell only 50 shares on the same day by 12:10 PM, carrying the remaining 50 shares to the next day, it is still considered as a day trade – even though you didn’t exit all of your shares.

Example 3 of a long trade: If you buy 50 shares of Apple at 09:45, again buy 50 shares at 10:15 and buy 100 shares once more at 11:00 AM, then sell 200 shares at 02:30 PM, this is considered 3 day trades.

Example 4 of a long trade, which is not a day trade: If you buy 100 shares of Apple at 10:00 AM on November 22 and sell the same on November 23, 12:10 PM, then it is not considered a day trade.  The “day” definition, for the purposes of pattern day trader, is a single business day—not a 24-hour period.

Example of a short day trade: If you sell short 100 shares of Netflix at 09:40 AM and then cover by 03:20 PM, the same day, it’s a day trade.

Now that we are clear about what a day trade is, let’s move on to “pattern day trading”.

What is pattern day trading (PDT), as defined by FINRA?

The FINRA website defines a pattern day trader as one who “day-trades four or more times in five business days and the day-trading activity is greater than six percent of the total trading activity for the same five-day period.”

Apart from the above rule, the brokerage firm has also been given some discretionary powers to designate a trader as a PDT, if the firm is certain or has a reasonable basis to believe that the trader is a pattern day trader.

FINRA site states that, “if the firm provided day-trading training to you before opening your account, it could designate you as a pattern day trader.” Surprising, but that’s how it is.

What happens if one gets classified as a PDT?

The minimum equity requirement for trading as a PDT is $25,001.  If you have $25,000 or less in your trading account, you will trigger PDT rules.  This amount (any amount over $25,000) has to be deposited in the account before one starts trading.  This amount has to remain in the account when you trade and it has to be left in the account for two business days after you close your final trade.

Example: Even if a PDT closes all of his open trades on Friday, November 18,  he is not allowed to withdraw the money from the account until Wednesday, November 23.

If the trader fails to maintain the equity margin requirement of $25,000, the brokerage firm will issue a day-trading margin call and the trader will have, at most, five business days to deposit the required funds, barring which, the account will be limited only to trading on a cash available basis or until the trader deposits the required funds.

Now that you are aware of how a trader gets classified as a PDT and the margin requirements of a PDT account, it’s time to give you a few tips to avoid getting classified as a PDT.

Open more than one account

If you are starting new and have limited funds, it is better to open different accounts with different brokerages. With funds split in two, you can make six day trades (three in each account) within a span of five days and still not be classified as a PDT.

How to do unlimited day trades with two accounts?

There are no rules barring someone from having multiple accounts and, as such, this is a legitimate method. Though this may entail higher commissions and statutory charges, it’s better than having your account frozen or being unable to execute a critical exit out of fear that it will trigger a PDT classification. 

That said, it is important to check with your broker.  If you open up multiple accounts with a single broker, it could be considered a single account for the purposes of determining your PDT status, depending on the broker.

Let’s look at an example:

Suppose you have accounts with Broker X and Broker Y. You want to day trade the Apple stock, as you believe it is having great momentum. So, you buy 100 shares of Apple stock in the account at Broker X. After three hours, when the time comes to close your position, instead of selling stock that you had purchased in the account with Broker X, you sell short in the other account created with Broker Y. That leaves you with a flat position.

Broker X               =Buy 100 Shares

Broker Y               =Short 100 Shares

Keep both the positions overnight and, the next day, close both of the positions at the same time, thereby closing both of the open positions.

Because you haven’t closed the trades on the same day, it doesn’t qualify as a day trade. Hence, using this technique, you can attempt any number of day trades.

However, there is a drawback. You will end up paying two extra commissions, brokerages and taxes. You will also have to cater for slippages, both while buying and selling, though, sometimes it might be against you and other times it might turn out in your favor.

Hence, slightly cumbersome, but worth a try.

Buy today and sell tomorrow to avoid PDT

The initial hour of trading at market opening and the last hour’s trading before market close are considered to be the most liquid. If you are able to identify stocks with strong momentum, it is better to buy the stock at the market close and hold the position overnight.

In a bullish market, stocks with strong momentum that end the day close to the high point of the day are likely to open strong next day. You can allow your money to work for you while you sleep. The next day, you can close your position right at the market open, when the liquidity is pretty high. Because the positions are being held overnight, they are not considered a day trade.

You can get additional information about PDT from other experienced traders.  If you are just starting out as a trader, a carefully chosen mentor can offer valuable advice to help you to avoid PDT pitfalls that ensnare many an unsuspecting trader.

If you’re new to trading, be sure to check out our post on getting started! Diving into the Stock Market world doesn’t have to be scary, just make sure you’re prepared! 

Join the discussion One Comment

  • PoLo_MeX says:

    Good and useful post for new traders, and again you make me laugh when you said: the pattern day trading rules, not the Girl Scout cookie rule… haha.

    I have one question… I have a CASH account with Interactive Brokers and I founded initially with $26k, but now I´m down and I only have $23k left, but for my surprise, I can do more than 4 day trades per week. For example I can do 10 day trades on a week and I don´t have problems. Why? Why the PDT rule does not apply to me?

    If you know the answer I will appreciate so much.

    Regards!

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