The Pattern Day Trading Rule in Detail

 

Back in 2001, the SEC instituted a new rule known as the “pattern day trading rule“.  This was in the wake of the dot com bust and regulators felt it was needed to help ensure that traders with smaller accounts would stop losing it all quickly by day trading.

 

After trying swing trading and day trading for many years, I would say its probably a good thing and not a bad rule for most traders.  I’ve made a lot of money swing trading over the years but lost overall while trying out day trading.  The performance is like night and day.

 

I was successful almost immediately when I tried swing trading top growth and UPOD stocks early in my career.

 

But whether you trade a small account or one over $25,000, you need to know what the rule really is and what could happen to your account.  You also need to know how it works whether you day trade with a larger account or even if you swing trade with a tight stop-loss.

 

There is a lot of disinformation online about this critical and sometimes scary rule to new traders.  So let me clear up some confusion.

 

The Pattern Day Trading Rule in Detail

 

The pattern day trading rule is a mechanism where “pattern day traders”, a trader who has made more than 3 daily roundtrips over a rolling 5 day period, are only allowed to trade if they have over $25,000 in their account.

 

The rule only applies to margin accounts – basically an account where you can borrow money from your broker to buy additional shares or a broker where you have instant settlement such as Robinhood.  Margin accounts allow you to use the funds from a stock sale immediately rather than wait for the 2 day settlement period.

 

The most important thing to know about the PDT rule is that you do not want to have the pattern day trader flag on your account.  So avoid doing more than 3 daily roundtrips over a rolling 5 day period.

 

Why do I say this?  Well, if you have the pattern day trading flag on your account, and the account goes below $25,000 before the market opens, you are stuck.  You can only close existing positions.

 

Yes, you read that right.  Your account is basically frozen.  You cannot trade again.  You can only close existing positions.  Not sure why no one else mentions this online but that is the way it works.

 

Of course, your broker will tell you “no problem, just add more money to your account so you have over $25,000 by the open of trading the next day”.

 

This is what usually happens to new day traders multiple times during their first few years.  They keep adding and then losing it.

 

If they become really great day traders, which generally takes many years unlike swing trading, then it probably will not be a problem.

 

However, even if your account is well north of $25,000 and has the pattern day trading flag, one trading halt on a stock and you could lose a ton, especially if you use margin, and be stuck being  able to close existing positions only.  This is a real risk of this when you trade stocks under $10.

 

Not where I want to be.

 

Now, if you do not have the pattern day trading flag on your account, being under $25,000 is not a problem.

 

If you have less than $25,000 in the account and do not have the pattern day trading flag on your account, you can swing trade (hold each trade at least 1 day) as many times as you like.  You can also do up to 3 day trades (3 round trips on the same stock the same day) over a rolling 5 day period.

 

A day trade or “1 round trip” means there is an executed buy order AND sell order for the same stock on the same day whether its pre-market, during normal trading or after hours.

 

Here is a good example so you know what a day trade or “round trip” is and how to avoid more than 3 same day round trips within a 5 day period.  Remember, once you have more than 3 within any 5 trading days, your account will be flagged as a pattern day trading account.  A flag that generally does not get removed.  More about this later.

 

Here is a good example so you know what 1 round trip really means.

 

Lets say you buy a thousand shares of stock A and sell 500 shares of stock A twice the same day as you bought it.  That would count as only 1 round trip.

 

Its counted as only 1 round trip because you have 2 executed sell orders but only 1 executed buy order on stock A.

 

If you buy stock B on the same day but do not sell any shares of stock B that same day (or vice versa), its not counted as a daily round trip obviously.

 

Have 2 executed buy orders and 2 sell orders the same day on the same stock and it would be 2 round trips.  Or, if you buy and sell stock A and also buy and sell shares of stock B that same day and you would have 2 daily round trips.

 

Again, you can only have 3 daily round trips over any 5 day period (5 trading days not calendar days).  Over 3 and you get the dreaded pattern day trading flag on your account for good.

 

Once your account has the pattern day trading flag, its frozen to closing transactions only if the account value is below $25,000.  You cannot start ANY new position.

 

Your broker should give you a count of the number of day trades you have left at any given time before you get flagged as a pattern day trader.  Thinkorswim has a “Day Trades Left” counter built-in but you may need to customize your account info widget in the upper left of your trading platform to view it.

 

But once you have the pattern day trading flag on your account, you cannot even swing trade if the account goes below $25,000 by the start of trading the next day (or is already below $25,000).  Your account is frozen.  A good online broker will give you a message when you have used up all 3 of your day trades within a 5 day period.

 

Again, none of this is a concern if you stay over $25,000 in the account (or add more so its over $25,000).  You can day trade all you want.

 

But once you go below $25,000 before the market re-opens, your account is frozen again (only if it has the pattern day trading flag) until its back over $25,000.

 

The most important thing to remember

 

Here is a critical distinction.  Remember this.  The flag does not come off once you get your account back over $25,000.  So one trading halt or big loss of any kind could bring your account below $25,000 and restrict your account to closing trades only if your account has the pattern day trading flag.

 

So the PDT rule is a big consideration for many retail traders. Especially for day traders since swing trades are held over night and will NOT trigger the pattern day trading flag on your account.

 

In the next blog post, we will discuss how to easily protect yourself from the pattern day trading rule and getting your account frozen while day trading.  Stay tuned.

 

Feel free to leave questions below and we can answer them for you.

 

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