A pattern day trader is a designation created by the Financial Industry Regulatory Authority (FINRA). A brokerage or investing platform will classify investors as pattern day traders if they day trade a security four or more times in five business days, and the number of day trades accounts for more than 6% of their total trading activity for that same five-day period.
When investors get identified as pattern day traders, they must have at least $25,000 in their trading account. Otherwise, the account could get restricted per FINRA’s day-trading margin requirement rules . Read on to learn more about the Pattern Day Trader (PDT) Rule and how it can affect an investor’s trading.
Why Was My Trading Account Restricted?
The PDT Rule established by FINRA requires that an investor have at least $25,000 in their margin account in order to conduct four or more day trades within five days. If the account dips below $25,000, the investor will have to deposit funds to bring the balance back up in order to day trade again.
A day trade occurs when a security is bought and then sold within a single day, according to FINRA. However, simply purchasing shares of a security would not be considered a day trade, as long as that security is not sold later on that same day, per FINRA rules. This also applies to shorting a stock and options trading.
All brokerage and investing platforms are required by FINRA, a nongovernmental regulatory organization, to follow this rule. Most firms provide warnings for their investors if they are close to breaking the PDT rule or have already violated it. Breaking the rule may result in a trading platform placing a 90-day trading freeze on the customer’s account. Brokers can allow for the $25,000 to be made up with cash as well as eligible securities.
Some brokerages may have a broader definition for who’s considered a “pattern day trader.” This means they could be stricter about which investors are classified as such and the restrictions that are placed. According to FINRA guidelines, a broker can designate an investor a pattern day trader as long as the firm has a “reasonable basis” to do so.
Does the Pattern Day Trader Rule Apply to Margin Accounts?
Margin trading is when investors are allowed to make trades with some of their own money and some money that is borrowed from their broker. It’s a way for investors to boost their purchasing power. However, the big risk is that investors end up losing more money than their initial investment.
Investors trading on margin are required to keep a certain cash minimum. That balance is used as collateral by the brokerage firm for the loan that was provided. The initial minimum for a regular margin account is $2,000. That minimum moves up to $25,000 if the investor is classified as a “pattern day trader.”
FINRA rules allow pattern day traders to get a boost in their buying power to four times the maintenance margin excess–any extra money besides the minimum required in a margin account. However, most brokerages don’t provide 4:1 leverage for positions held overnight, meaning investors may have to close positions before the trading day ends or face borrowing costs.
If an investor exceeds their buying power limitation, they can receive a margin call from their broker. The investor would have five days to meet this margin call, during which their buying power will be restricted to two times their maintenance margin. If the investor doesn’t meet the margin call in five days, their trading account can be restricted for 90 days.
Does the Pattern Day Trader Rule Apply to Cash Accounts?
This is up to the brokerage or investing firm. Some trading platforms only apply the PDT rule to margin accounts and don’t apply it to cash accounts. In cash accounts, all trades are done with money investors have on hand.
However, some platforms may adhere to FINRA rules that govern margin accounts even if they don’t offer margin trading. This means that even in a cash account, a $25,000 minimum balance must be kept in order for an investor to do more than four day trades in a five-business-day window.
Investors with cash accounts also need to be careful of free riding violations. This is when an investor buys securities and then pays for the purchase by using proceeds from a sale of the same securities. Such a practice would be in violation of the Federal Reserve Board’s Regulation T and result in a 90-day trading freeze.
How to Avoid Becoming a Pattern Day Trader
Here are some steps investors can take to avoid getting a PDT designation:
1. Investors can call their brokerage or trading platform or carefully read the official rules on what kind of trading leads to a “Pattern Day Trader” designation, what restrictions can potentially be placed and what types of accounts are affected.
2. Investors can keep a close count of how many day trades they do in a rolling five-day period. It’s important to note that buying and selling during premarket and after-market trading hours can cause a trade to be considered a day trade. In addition, a large order that a broker could only execute by breaking up into many smaller orders may constitute as multiple day trades.
3. Investors can consider holding onto securities overnight. This will help them avoid making a trade count as a day trade, although with margin accounts, they may not have the 4:1 leverage afforded to them overnight.
4. If an investor wants to make their fourth day trade in a five-day window, they can make sure they have $25,000 in their brokerage account the night before.
5. Investors can open a brokerage account with another firm if they’ve already hit three day trades over five days with one trading platform. However, it’s good to keep in mind that the PDT rule is meant to protect investors from excessive risk taking. It’s also important to know that taking time to make investment decisions could be in the investor’s favor.
Why Did FINRA Create the Pattern Day Trader Rule?
FINRA and the Securities and Exchange Commission (SEC) created the PDT margin rule amidst the heyday of the dot-com bubble in order to curb excessive risk taking among individual traders.
FINRA set the minimum account requirement for pattern day traders at $25,000 after gathering input from a number of brokerage firms. The majority of these firms felt that a $25,000 “cushion” would alleviate the extra risks from day trading. Many firms felt that the $2,000 for regular margin accounts was insufficient as this minimum was set in 1974, before technology allowed for the electronic day trading that is popular today.
Brokerage and investing platforms are actually free to impose a higher minimum account requirement. Some investing platforms impose the $25,000 minimum balance requirement even on accounts that aren’t margin accounts.
It’s important for investors to understand the Pattern Day Trader rule when they start out investing. With SoFi Active Investing, investors can start buying and selling stocks and exchange-traded funds (ETFs) with as little as $1.
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