OAP 045: Pattern Day Trading Rules – What Are They & What Can Go Wrong?

Options Trading
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The pattern day trading rule prevents people with less than $25,000 in their investment accounts from engaging in day trading. Many misunderstand the rule, however, and it generally does not operate to the detriment of most options traders.

In the article below, we'll discuss FINRA's pattern day trading rules, how they might negatively affect you, and how you can avoid their grasp.

What Is a Day Trade?

A day trade is exactly what it sounds like. It involves entering and exiting the same position inside of a single trading day.

Due to the broad scope of the term "day trading" in common vernacular, many people assume that it encompasses activities that aren't actually captured by the definition. For example, buying a stock or entering a position on Monday and selling the same stock or exiting the position on Tuesday is not a day trade. "Day trading" is not synonymous with a short period between opening and closing a position.

Similarly, buying one stock or entering a position and selling a different stock or exiting a different position on the same day is not a day trade.

To be clear, options trading can count as a day trade. Because of the more complicated nature of options trading, brokers will often consider a series of transactions as counting as a single day trade.

For example, if you open ten positions at once but close them out on the same day one at a time, that typically won't count as ten day trades. It will be counted as a single day trade.

Similarly, if you open a spread (a combination of options on the same underlying security but with different strike prices or expiration dates) and close it out on the same day, the entire spread will normally be considered one day trade. The individual contracts that make up the spread won't each be counted against your three day trade limit.

What Is a Pattern Day Trader?

A pattern day trader is anyone who meets the following criteria:

  • A person who engages in four or more day trades within five continuous business days
  • The day trades account for six percent or more of their trading activity during that period.

For example, a person who executes two day trades on Monday, two day trades on Tuesday, and has no other trading activity would qualify as a pattern day trader. See this link for the Financial Industry Regulatory Authority's description of pattern day trading.

There is a second way to be designated as a pattern day trader. If the investment firm has reasonable grounds to believe you will engage in pattern day trading, it is required to label you a PDT. So, for example, if you took a class on day trading offered by that firm before opening your account, you may be designated a PDT.

A pattern day trading designation is usually permanent. Once you've been tagged as a PDT you will need to comply with the margin requirements described below. However, if you change your trading strategy, you can contact your brokerage and request that your account be recoded. Whether your brokerage grants your request is a matter within their sole discretion.

What Does the Pattern Day Trader Rule Proscribe?

The pattern day trader rule (the "PDT rule") prohibits margin pattern day traders from day trading out of an account that contains less than $25,000 in equity.

The rule is intended to address the additional risks posed by day trading and attempts to ensure that pattern day traders will have enough equity to meet any potential margin calls.

Failure to meet the equity requirements results in the trader facing restrictions with respect to their ability to sell or close out positions they've opened.

The Pattern Day Trader Margin Call

If a pattern day trader trades more than four times the maintenance margin excess in the account as of the close of business of the previous day, the brokerage will issue him or her a margin call. The trader will then have up to five business days to deposit the funds to meet this margin call. In the meantime, the trader will be limited to day trading buying power of only two times maintenance margin excess.

If he or she does not make such a deposit, the pattern day trader will be limited to trading on a cash basis for 90 days or until the margin call is met.

How Do I Avoid Being Tagged As a Pattern Day Trader?

The simplest way to avoid being labeled a PDT is to refrain from making more than three day trades within five rolling business days. Additionally, keep the following in mind:

  • Individual options contracts aren't necessarily considered day trades if they're part of a spread or larger order. Know the rules your particular brokerage has with respect to options day trades as they vary from firm to firm.
  • Remember that the five-day rolling window counts business days, not calendar days. If you make three day trades on Friday, then make another one on the following Thursday, you may get flagged as a PDT.
  • If you use an online brokerage, the user interface should include a running total of how many qualifying day trades you've engaged in over the past five business days. Keep an eye on that total.
  • Don't give the brokerage any reason to believe you are, or will be, a day trader. This includes enrolling in classes offered by the firm on day trading, for example.

In short, if you don't want to be designated as a day trader, don't execute day trades.

Am I Likely to be Designated a PDT if I Trade Options?

If you follow the strategies recommended by Option Alpha, you likely won't get tagged as a pattern day trader. Basically, we at Option Alpha are position traders. We recommend to people that they get into positions, and stay in those positions, for at least a few weeks or months at a time.

While we may exit a position early if there is profit in it, it would be a rare situation that we planned to get into and out of a position on the same day. Of course, we may need to do so to unwind a position we've opened or a security we've bought in error. It goes without saying, though, that these errors are not so frequent we would bump up against the three day trade limit on a regular basis.

As we indicated above, trading unrelated securities or options on a single day does not qualify as day trading. It is only when a trader buys a security or opens a position and sells that security or closes that position on the same day that the day trade classification is met. Therefore, the pattern day trading restrictions don't really limit our ability to engage fully with the market.

We generally advise retail investors against engaging in strategies so aggressive that they could be classified as pattern day traders. We believe firmly in our approach to trading options and, as we mentioned earlier, that approach does not include regular day trading.

Basically, if you wish to use options to generate monthly income, we suggest that there's no need to engage in regular day trading. You should leave your three allowed weekly day trades for the occasional time you'll need to close out a position you've opened in error. Instead, focus on making trades that set you up for profit over a period of weeks or months.

Final Thoughts

Pattern day trading rules are triggered when you make more than three qualifying day trades over a five-business-day period. Being designated a pattern day trader is not the end of the world. It will, however, create restrictions on your ability to trade on margin if you don't have at least $25,000 of cash or qualifying securities in your account. It can also cause your firm to make a margin call if you fail to keep track of your use of buying power in your margin account. Finally, you may find yourself unable to exit positions that you've opened earlier in the day.

A typical options trader who uses the strategies they find in Option Alpha will not find themselves regularly being designated a PDT. Since we aim to enter positions for a number of weeks or months, we rarely engage in the types of trading (rapid buying and selling of the same security or derivative on the same day) that would be qualified as a day trade.

As a rule, if you keep an eye on your rolling day trade total on your online brokerage's user interface, and you limit your day trades to the occasional transaction necessary to unwind a mistaken position, you'll remain unaffected by the PDT designation. Further, because day trading doesn't limit you from otherwise acting aggressively in the market, your ability to trade will not be negatively affected.

Key Points from Today's Show:

  • In options, a day trade is defined as entering an options contract and then closing it out on the same day. When you exceed the day trade limit, you will be tagged as a pattern day trader.
  • It is important to know that the pattern day trading rule only applies to accounts with less than $25,000 of equity, and to anyone who is an active trader.
  • Main rule: you are allowed three day trades in a five day trading period. If you make the fourth day trade within that five day trading period, you will be permanently tagged as a pattern day trader until you get your account over the $25,000 limit.
  • Note that different brokers have different requirements and policies for when you get tagged as a PTD — talk to your broker to be informed.
  • Brokers do recognize option spreads and the intent you have to close out of these positions. Entering an entire spread and closing out an entire spread, does not mean that each of the option contracts counts as a day trade.
  • When you get tagged as a PTD you may still enter new trades but will be restricted in your ability to get out of the trades, and depending on the broker, may be faced with a 90 day suspension and review period, or will be required to add additional funds to get up to the $25,000 limit.
  • Your individual broker will have a record of your day trades and how many you have left within the five day trading period — know where this is posted to keep track of your day trades, especially as a new trader.

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Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to properly scan for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]: Honestly, this module isn't just for professional traders; it's for anyone who wants to eventually have options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [40 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type in order to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • IWM Iron Butterfly (Closing Trade): Exiting this IWM iron butterfly options trade gave us a $1,100+ profit after pinning the stock price one day before expiration at the peak of our spread.
  • CMG Iron Condor (Opening Trade): I just recorded my live trading platform (and real money account) as I walked through the process of entering a new iron condor trade in CMG stock. Inside you'll see me analyze, price and fill the trade in real-time.
  • APC Strangle (Closing Trade): Took about $150 out of this small APC strangle trade even after the stock moved completely against our call short strikes this month. But as always, implied volatility always trumps direction and because IV went down, the value of this spread dropped more-so than the impact of the directional move higher.
  • IYR Call Credit Spread (Adjusting Trade): This adjustment is good for 2 reasons. First, it reduces the overall risk in the trade if IYR continues to move higher. Second, it still leaves room for the stock to fall back down into our new profit window.
  • XHB Straddle (Closing Trade): We were able to bank a $120 profit early in the March expiration cycle for our XHB straddle with the stock trading right in the middle of our expected range.
  • AAPL Call Calendar (Opening Trade): Look behind the scenes as I use our new watchlist software to quickly filter and find this AAPL call calendar spread trade during overall low implied volatility in the market.
  • COF Strangle (Adjusting Trade): Here I recorded my live trading screen (and real money account) showing you the entire thought process we used to make an adjustment to my current short strangle in COF to reduce risk.
  • GDX Strangle (Opening Trade): With gold's high IV we are getting into a new strangle with a 70% chance of success and a decent credit for selling option premium.
  • IBB Iron Condor (Closing Trade): Today we're exiting an iron condor we traded in IBB for a $142 profit. Inside you'll see me analyze the exit price and fill the trade in real-time.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.