Pattern Day Trading Rule – What it is and how to avoid it
Dec 30, 2022
Written by: Al Hill
Ugh, the pattern day trading rule! The name causes some discomfort to many traders. But then, rules are meant to be broken right? In the world of retail trading in stocks, this rule is hard to avoid. However, there are solutions. We’ll walk you through the ins and outs of the PDT rule in this article.
Table of Contents
The PDT Issue
If you trade too much, chances are that your account will be flagged as a pattern day trader or “PDT”.
When your account is identified as one, the restrictions kick in. Many traders find it frustrating when the regulations kick in. Some immediately blame their brokerage. But this is a regulation put down by FINRA and the SEC.
Sometimes, trading opportunities are dime a dozen. The average trader obviously ends up ignoring the rules only to regret them later after their account is frozen from taking too many trades. Therefore, it is understandable why one would get frustrated with the pattern day trading rule restriction.
The Pattern Day Trading Rule Prevents You From Trading
Ironically, the pattern day trading rule was developed keeping a trader’s “best interest in mind.”
We’ve written extensively about the habit of new traders to “overtrade.” Well, the PDT rule is a way to force you to think more about the trades you’re taking. But is it really necessary?
Think about it for a moment. What if you were told that you could not day trade for 90 days? What if you were told that you need to top up your account before you could trade?
That would make you furious, wouldn’t it?
After all, traders, and especially those who trade on margin, prefer to keep just the right amount in their accounts and trade on leverage.
Why would you want to keep excess funds in your brokerage account when it can earn interest elsewhere?
Welcome to the world of the pattern day trading rule, which is one of the biggest obstacles traders struggle with in the United States.
Definition of a pattern day trader
The legal definition of a pattern day trader is one who executes four or more day trades in five consecutive business days. This is applicable when you trade a margin account. When a trader is classified or flagged as a pattern day trader, they attract a 90-day freeze on the account.
Traders need to maintain a minimum balance of $25,000 on their account at all times when using a margin account.
The criterion for pattern day trading varies. There are some exceptions. For example, long and short positions kept open overnight but sold prior to the new purchases of the same security on the next day are exempt.
The pattern day trading rule severely limits participation in the market and also affects liquidity. This also leads to an increase in risk on the trader’s side.
Given the fact that most traders start out with smaller capital, it can be devastating to their trading journey.
History of the PDT rule
The pattern day trading rule came into effect in 2001, right after the collapse of the dot com bubble. In the run-up to the bubble, many traders categorized themselves as a day trader. Staying long in the market, traders eventually got margin calls when they were caught on the wrong side of the market correction.
As a result, the Securities and Exchange Commission (SEC) and the FINRA were led to enact the Pattern Day Trading Rule. This is also known as Rule 2520.
The goal was to prevent traders from being too over-leveraged and to maintain a considerable amount of funds to protect themselves from margin calls.
So, to summarize, if you don’t maintain a minimum balance of $25,000 in your margin trading account, you cannot trade more than three times in five consecutive trading days.
Drawbacks of being a Pattern day trader
Note that the pattern day trading rule applies only to margin accounts. A margin account is one which allows traders to trade on margin or leverage their capital. In other words, these are borrowed funds.
For example, if you had $50,000 in your margin account, you could trade two or four times this capital. This, in essence, increases your capability to $100,000 or even $200,000. It also allows you to continue trading each day while your funds are “settling.”
In all fairness, it is easy to see why the pattern day trading rule was formed. There is a big risk when trading on leverage and the PDT rule helps to keep you grounded.
If you trade with a normal unleveraged account, a cash account, the PDT rule does not apply because you are not borrowing funds in the first place.
But at the same time, this also limits your ability to day trade. In this account type, you, of course, avoid margin fees but it takes three days for trades to settle.
This can be a long wait. You also cannot short sell stocks, which you can in a margin account. Lastly, your buying power directly relates to how much cash you have in your account.
But there are some inherent drawbacks to being a pattern day trader too. Here are some of them.
Pattern Day Trading Rule Minimum balance requirement
When you are classified as a pattern day trader, you need to maintain a minimum balance of $25,000. This amount has to be maintained at all times. It is this criterion that the SEC uses to determine you as a trader.
In the event that your balance falls below $25,000 you would be asked to either replenish your account or the regulations kick in; even if it means that your balance declines by a dollar.
The minimum balance requirement can be a deterrent for many traders. Most day traders prefer to trade on margin. They make use of leverage to their advantage.
This means that traders don’t have to keep all their funds with their broker. They could easily use the funds toward other investments. But this is a misconception.
According to the Securities Investor Protection Corporation (SIPC), your securities account is protected up to $500,000 with a cash claim of up to $200,000.
When a trader is flagged as a pattern day trader, they are forced to maintain the minimum balance.
The label of being a pattern day trader with your brokerage
It is important to note that you are classified a pattern day trader based on your execution of trades; the trades that you buy and sell during a business day.
The rule leads many traders to avoid being classified as one. Traders, therefore, end up holding their positions overnight or over a period of days.
This can be risky especially when there is a big move in the after or pre-market trading sessions.
Restrictions on trading
The moment your trading account is flagged as a pattern day trader, your ability to trade is restricted. Unless you bring your account balance to $25,000 you will not be able to trade for 90 days.
Some brokers can reset your account but again this is an option you can’t use all the time.
What happens when you are flagged as a PDT?
This is a common and an obvious question that comes to mind. What happens when you are flagged as a pattern day trader and when your balance falls below the $25,000 requirement?
Well, you will have the following options.
You can either top up your balance to bridge the gap and make your balance to meet the minimum requirements.
In some cases, you will have to wait for a 90-day period before you can initiate any new positions. That’s about a three month wait before you can trade again.
Depending on the broker you are with, you can also ask for a pattern day trader or a PDT reset.
When the balance falls below $25,000 you will be prohibited from initiating any new positions almost immediately. You will have to close out any existing positions in order to revive your account back to the minimum balance requirement.
A pattern day trading reset (or PDT reset) is, of course, the best course of action. FINRA allows brokerage firms to remove the PDT flat from a customer’s account once every 180 days. When the PDT flag is removed, you can place about three trades every five business days.
How to Avoid the Pattern Day Trading Rule
It’s a common annoyance for a day trader to have pattern day trader status. However, there are some actions that day traders can take to remove pattern day trading rule status. Here are some common ways to avoid that label.
1. Open a cash account
If a day trader wants to avoid pattern day trader status, they can open cash accounts. They can make unlimited day trades with smaller amounts of money. While you can make unlimited trades, there is a downside.
The Securities and Exchange Commission rules state that cash profits from a transaction must settle before traders can receive the cash. That means that traders can’t use the cash until two days after the settlement date.
For example, a trader has $20,000 in their account and makes a day trade using $5,000 from the cash account. They can trade with $15,000 for the next two days. Brandon Herman, Senior Manager of Margins and Clearing at TD Ameritrade, explained the settlement rules here:
“In a cash account, if you buy and you sell, you have to wait for that sale to settle before you can use the funds again. Some clients may find it worthwhile to use a margin account every now and then to be able to buy what they want to buy, when they want to buy it, and borrow with margin for a short period of time,” said Herman.
If day traders want to trade a small amount of money and are patient, cash accounts can be an option to avoid PDT status.
2. Use multiple brokerage accounts to avoid the PDT Rule
If trading three times a week is too limiting for day traders, having more than one brokerage account may be another option. When a day trader opens multiple brokerage acccounts, they can have an additional three trades for every five days. Because many brokerages have commission-free trading, this can be a viable option to avoid PDT restrictions.
While opening multiple accounts is one way to avoid PDT status, day traders should be cautious. Having too many accounts open may spread a day trader’s funds really thin. If a day trader has funds below $25,000 in their account, their funds may get depleted quickly.
Another downside is keeping track of the profits and losses in multiple trading accounts. A Google doc or Excel spreadsheet can help day traders keep track of their multiple accounts.
3. Have an offshore account
If U.S. brokerage accounts are too restrictive, then offshore brokerage accounts are another option. Day traders can open offshore accounts and trade more often with fewer restrictions.
If a day trader opens an offshore account, they should be cautious. The rules that govern U.S. investors may not apply. The protections offered to investors may not be present, either. There may extra fees to open these accounts as well.
4. Trade Forex and Futures to avoid the PDT Rule
In addition to having an offshore account, day traders can avoid the PDT Rule by trading foreign currency or futures. Neither of these asset classes require a certain level of cash. In fact, you can open an account with many brokers for just a few thousand dollars.
Some things to watch out for are the massive amounts of leverage inherent with trading these accounts. You’ll need to be disciplined to understand how to trade Forex and Crypto.
5. Options trading
Options trading is another choice to avoid PDT restrictions. James Schultz, an options trading expert, spoke here about options trading.
Schultz explained how he started trading options.
“The simple fact that the only unknown variable in the model, the implied volatility, was consistently higher than the realized volatility that actually unfolded in the market left me convinced that there was an opportunity in trading options, ” said Schultz.
Schultz explained how day traders can start trading options.
“Start very small and focus exclusively on defined-risk strategies, until you’re comfortable with how the market moves and your options positions bounce around,” said Schultz.
“While a virtual, “paper” money account is useful for learning the mechanics, it cannot and does not simulate the actual emotions that are felt with real, live trading. So, even if it’s only a small amount of money, start with small trades in a real money account, as soon as you can,” added Schultz.
Offshore Brokers with no PDT restrictions
Now to the best part! There is at least one reputable broker we’re aware of, possibly two, through which you can avoid being labeled a pattern day trader.
But you might already guess that this is an offshore brokerage. The offshore jurisdiction gives these brokers more flexibility. This means such brokers can also avoid having to follow the FINRA rules.
But if something goes wrong, chances are that you do not get the same level of assurance as a trader trading with a U.S. registered brokerage. You are also liable to pay higher commissions. But this is a trade-off considering that you want to avoid the pattern day trading rules.
Here are some of the brokers that have no pattern day trading rule restrictions. They also allow you to trade on margin.
Capital Markets Elite Group (CMEG)
CMEG is based out of Trinidad, though their banking is done through an Australian bank. One of our staff members has actually used this service and can recommend it.
Although they allow you to open an account with as little as $500 on their active trading service, margin goes all the way up to 6:1 around $2500.
In our experience, the service was very reliable, with order executions lightning fast. The only thing we would complain about are commissions. With a small account, commissions and fees can add up really fast. So can network fees, wiring fees, and platform fees. Just be aware of this.
One positive of CMEG is that they do have access to hard to borrow stocks. So, if you’re a short seller, this may be of interest to you. Regardless, it will like you cost you about $300+ just to get started with either the DAS or Sterling trading platforms, along with wiring fees, etc.
AllianceTrader is the brand name for Alliance Investment Management limited. It offers online equity trading service and the company is domiciled in Jamaica. The company is licensed by the Financial Services Commission of Jamaica under the securities Act of 1993.
For the record, we have not tried this service, nor do we know if it is real. We did try to call them, but got a voicemail for MagicJack.
According to their website, AllianceTrader allows you open an account for as little as $1000 for a cash account or $2000 for a margin account. You get a leverage of 4:1 on your margin account. This means that if you deposit $2000 in a margin account, your leverage goes up to $8000.
Of course, the leverage falls to 2:1 if you keep positions open overnight.
The brokerage claims to have no annual fee and no trade restrictions on intraday securities buying and selling.
There is an intuitive trading platform that allows you to place multiple stop orders and advancing charting techniques. You can either download the trading platform or use the web-based version.
If you are interested, you can get a two-week demo as well to test drive the trading platform.
TradeZero is another broker that circumvents the pattern day trading rule. The company is domiciled in the Bahamas. However, note that the brokerage does not allow accounts from U.S. citizens. This is a bit disappointing considering that you can open a margin trading account for as little as $500.
They also offer higher leverage of up to 6:1 when you deposit $2,500 or more. Limit orders are offered free of cost and regular market orders come at a certain fee.
TradeZero offers its own proprietary trading platform that can be downloaded or accessed via the web. Other versions include dedicated smartphone apps as well.
There is also a free demo version for you to test drive their platform.
Suretrader used to be another option for brokerage from the Bahamas. We mention it because it is still talked about in forums. They are closed down now, however.
Margin account or cash account or offshore account?
In conclusion, you can see that there are basically three choices available for you as a trader. Each of the accounts has its own pros and cons.
A margin account as you know gives you the option to leverage your trades by trading on margin. However, if you trade too much or if your balance falls below the $25,000 threshold you end up being marked as a pattern day trader.
This could potentially restrict you from trading by up to 90 days.
On the other hand, a cash account clears you of the PDT restrictions. However, your buying power is vastly restricted to the amount of capital you have. While there are some advantages you will be limited unless you have a huge capital to trade with.
Finally, you can choose an offshore brokerage that can allow you to circumvent the pattern day trader rule restriction. While this seems like a good compromise, remember that there are some risks.
Because the brokerages are offshore, the FINRA or SEC rules do not apply. This means that in the event the brokerage goes bust, it would be difficult to get your money.
While the odds of this happening are little, there is always this risk that you need to bear in mind.
To summarize, many traders do not like the pattern day trader rule. However, remember that the rule came into effect following the dot com bubble burst. Trading on margin is always risky, which is why the rules such as pattern day trader have been implemented.
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