Day trading rules and pattern day trader violations may confuse traders. There’s nothing to be afraid of once you understand the simple rules that outline pattern day trading (PDT) rules.
A day trade is when you buy and sell a security within the same day.
For example, if you purchase 100 shares of Apple after the opening bell and then sell those shares before the end of the day, it is a day trade. Similarly, opening and closing an options position on the same day is also considered a day trade.
The PDT rule was introduced in 2001 by the Securities and Exchange Commission (SEC). The rule states that investors who make four or more day trades in a five-day period are considered pattern day traders and must maintain a minimum account balance of $25,000.
FINRA sets the $25,000 portfolio value requirement and brokers are required to enforce the rule. You can learn more about day trading rules on FINRA’s website.
The purpose of the rule is to protect investors from excessive risk-taking, but some critics argue that it places undue restrictions on trading activity. Nevertheless, the rule is still in place and continues to be enforced by the SEC.
Generally, if you place your fourth day trade in the 5-day window, your brokerage account will be flagged for pattern day trading for 90 calendar days. This means you won’t be able to place any trades for 90 days or until you bring your account balance above $25,000.
If you day trade while marked as a pattern day trader and your balance is below the $25,000 equity requirement, you will be issued a day trade violation and be restricted from purchasing for 90 days. During this time, you can only enter closing trades.
Day trading rules and cash accounts
A cash account is a type of brokerage account in which the investor must pay for securities in full, using only cash or cash equivalents. Cash accounts are also known as "settled funds" accounts. The key difference is that settled funds must be used to pay for securities in a cash account, whereas margin accounts can be used to buy securities with borrowed funds.
Cash account day trades are not limited. However, you can only day trade with settled funds.
Day trading in a cash account is permissible as long as the trades do not violate the free-riding rule. A free-riding violation occurs when you buy securities and then pay for that purchase by using the proceeds from a sale of the same securities. This practice violates Regulation T of the Federal Reserve Board.
Trades made in violation of this rule are subject to broker rejection.
While free-riding violations and good faith violations are often interchanged, they are not the same thing. A good faith violation (GFV) occurs when a cash account buys a stock or option with unsettled funds and liquidates the position before the settlement date of the sale that generated the proceeds.
A good faith violation occurs when you haven’t paid for purchases with settled funds. There are two types of settled funds. The first type is cash. The other type is proceeds from a sale of a security that’s been fully funded. It’s the second type of settled funds that can confuse traders. Exactly when a security sale settles depends on the product, but the standard for equities is the trade date plus two days (known as “T+2 settlement”).
Day trading rules and cryptocurrency
The Pattern Day Trader rule, as defined by FINRA, does not apply to crypto trades as there are no limitations on day-trading cryptocurrencies.
At this time, day trading limits don't apply on cryptocurrencies because they’re not regulated by FINRA or the SEC like stocks and options.
Avoiding PDT violations
The simplest answer is to selectively day trade. Sure, there are opportunities to profitably enter and exit positions in the same day. But, if you have less than $25,000 in your account, you need to be selective so that you do not exceed three day trades in five market sessions.
Holding a position overnight subjects you to market risk, but avoids adding to your day trade count.
For example, buying an option near the close on Monday and then selling the position on Tuesday morning does not qualify as a day trade. Although you may only hold the position for minutes of “market hours,” maintaining the position overnight avoids PDT issues.
Growing your account through investment gains or depositing additional funds so that it is above $25,000 eliminates PDT worries. When your account is above $25,000, PDT restrictions do not apply and you can move in and out of day trades as you choose. Remember, if your account drops below $25,000, you are subject to PDT restrictions again.
With Option Alpha’s autotrading platform, you can use decision recipes to avoid the PDT rule automatically.