Pattern Day Trading Guide
The Pattern Day Trading Rule has an enormous impact on active US traders, whether you are familiar with it or not. It’s vital that you understand this rule, as running afoul of it will seriously curtail your ability to trade.
What is the Pattern Day Trader Rule?
The Pattern Day Trader rule (PDT) was implemented in 2001 with the goal of protecting unsophisticated investors from losing their money due to over-trading and excessive use of margin. The burst of the Dotcom Bubble had wiped out a lot of retail traders, who had grown used to a raging bull market and were unprepared to deal with anything else. According to FINRA:
The rules adopt the term “pattern day trader,” which includes any margin customer that day trades (buys then sells or sells short then buys the same security on the same day) four or more times in five business days, provided the number of day trades are more than six percent of the customer’s total trading activity for that same five-day period. Under the rules, a pattern day trader must maintain minimum equity of $25,000 on any day that the customer day trades. The required minimum equity must be in the account prior to any day-trading activities. If the account falls below the $25,000 requirement, the pattern day trader will not be permitted to day trade until the account is restored to the $25,000 minimum equity level.
1 buy AND sell counts as 1 day trade. Note that swing trading, which involves holding a stock overnight, does not fall under the PDT.
How Does it Work?
When you make a trade, it can take up to 3 days for the funds to settle. In a cash account, you cannot trade with those funds during that period of time, as they are not available. In essence, you have not yet received the proceeds from your sale.
As an active trader, you instead want to use a margin account. This is the type of account day traders should use. With a margin account, the broker provides credit, so you don’t have to wait for funds to settle – you can sell out of a position and then immediately use those funds again. Essentially, you are using borrowed money.
The amount of margin you have is your buying power. For day trades, this is generally 4x, meaning you will have $200,000 worth of buying power with a $50,000 account. This is very powerful, as it allows you to make many trades throughout the day and use far more money than you actually have. But remember, the PDT states that you will need at least $25,000 in your margin account if you plan to day trade. If you violate that, placing day trades when your account value is less than $25k, most brokers will give you a warning at first. If you do it again, they will freeze your account for 90 days, or until you deposit funds or securities that bring your account value back over $25k.
Remember, margin multiplies your profits, but also your losses. For example, if you use your full $120k day trading buying power from a $30k account, a 5% drop will mean a $6k loss, taking you below PDT and wiping out 20% of your capital! This is doubly true with shorts. Because you are obligated to buy back the stock regardless of how high it goes, your losses are theoretically unlimited. Add 4x margin and those losses will pile up four times as quickly.
How do I navigate the PDT and day trade safely and profitably?
To day trade, you will need a margin account and at least $25,000. I say “at least,” because in the course of trading you will lose some money, at times. If you start out with exactly $25k and lose $100 your first day, you are now under the limit. So, I usually recommend $30k, as that extra $5k will give you a buffer.
If you don’t have $25k – and many new traders do not – you can start with swing trading. This will give you time to build your account, and many of the skills you learn swing trading will apply to day trading too.
Whether you are swing trading, day trading, or both, it’s absolutely essential that you practice good risk management. This means sizing your positions appropriately, setting stop losses before you enter your trades and then honoring them, and knowing where to scale out. I cannot emphasize this enough: it doesn’t matter how much money you start with or how great you are at looking at charts, if you can’t manage risk you will lose it all.
Finally, have a good trading strategy. The PDT rule was implemented in the first place to keep reckless traders from throwing money at any stock with a pulse. Don’t be that guy. Educate yourself. We have a ton of great free content on our Youtube page and blog to get you started. Once you are ready to take the next step, our Bootcamp course teaches you our complete trading strategy.
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