Pattern Day Trading Rules – What Are They & What Can Go Wrong?
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.
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.