The SEC felt that folks with smaller margin accounts can’t make wise decisions for themselves, so they created a special rule limiting their day trading behavior in order to “protect” them.
If you’ve been lucking enough to have avoided it thus far, you may be asking…..what happens if you make that fourth day trade?
It depends on the individual broker, as some are stricter then others with first time offenders.
At the very least, the account will likely get flagged and monitored for repeat offenses, and ultimately frozen if the pattern continues.
Either way, whatever punishment your broker decides to bestow upon you, its best not to be at their mercy in the first place. But in order to be able to deal with the rule head on, you must first know what it is…
What Exactly is the PDT Rule?
The PDT or Pattern Day Trading rule states that any trader with a margin account size less then $25,000 must limit themselves to three day trades within a 5 business day period.
A day trade is defined as a security that is bought and sold within the same trading day, including pre-market and after hours. The 5 business days are rolling, meaning that weekends and holidays don’t count.
In other words, if you took three trades on Tuesday and decided to take a fourth trade on the following Monday, you would be dinged as a “pattern day trader” and get in trouble.
It becomes obvious fairly quickly how cumbersome this rule can become, especially when there are many ripe trading opportunities out there all at once so…..what are the ways that we can avoid it?
Use a Cash Account
The PDT rule only applies for day traders using margin accounts. This means the issue can be avoided entirely if a cash account is used instead.
There are drawbacks to this method unfortunately…
Part of the reason that most traders use margin accounts is that there are settlement procedures that are followed across most of the industry, which lock up capital from a position for a period of time after it is already closed!
The current standard is a T+2 settlement procedure for stocks, with a T+1 procedure expected to be implemented in 2024. T+2 settlement means that it takes 2 business days for the cash to be settled after a position is closed.
This is a problem, because it likely means that an extensive amount of a trader’s capital will be locked up in settlement at any given period of time.
Use Offshore Brokers
Due to the fact that this is a US regulation, brokers based in other countries don’t have to abide by the PDT rule. As with any of the work arounds though, it has its downsides.
US based customers are tricky for foreign brokers to deal with, which means that there are not many such brokers to choose from…..and the ones that do exist are not exactly first rate options.
Sign up with Multiple Brokers
This is probably the easiest option of the bunch…
The sign up process is typically not too complicated, so it shouldn’t take too much time to open up accounts with 2-3 brokers at once.
The downside is that different brokers utilize different trading platforms, so you will likely have to learn how to use multiple ones……On the plus side though, you will now be able to take an additional three day trades for each separate account.
Don’t Avoid It
It may seem like a non-answer, but the reality is that three day trades within a 5 day period may be enough for most individuals, if utilized strategically.
In other words, we would be focusing on the quality of the trading setups over the quantity in order to stay within the 3 day trade threshold.
Another thing to keep in mind is that, a broker will only count a trade towards the PDT rule if the stock is bought and sold within the same trading day. This means that one can take a combination of day trades and multi day trades to stay compliant.
Be careful though…
Its best not to place oneself in a situation where the three day trades have already be utilized, and a position is held overnight sole for the reason of not getting flagged as a “pattern day trader”
There is no ideal approach, but some may be more suitable then others depending on trading style, attitude towards brokers, and willingness to deal with the shortcomings of a cash account.