Day Trading Rules

Everybody can start trading on financial markets easily and quickly by opening a brokerage account. However, starting to day trade stocks or other instruments on the U.S. markets is a whole different story. The existing regulatory day trading rules make the entire process a bit more complicated.

This article explains the most important day trading rules in detail:

  • Pattern Day Trader Rule
  • Wash Sale Rule
  • Uptick Rule

Pattern Day Trader Rule

The best way to remain compliant and ensure a seamless day trading experience is to get familiar with the rules. This guide will walk you through the history of the pattern day trader rule and explain what it is and how to comply with its requirements. As a result, you will ensure that you will avoid violating the pattern day trading rule and suffering from the resulting trading restrictions.

What Is the Pattern Day Trading Rule by the Financial Industry Regulatory Authority (FINRA)?

According to FINRA rules, a trader qualifies as a “pattern day trader” if:

  • A trader executes four or more day trades within a five business day period within a margin account (the rule does not apply to cash accounts).
  • The rule mandates that the number of day trades represents more than 6% of the trader’s total trades in the margin account for that same five day period.
  • The rule covers all securities, including options trades.

A day trade is a position opened and closed within the same trading day in a trading account. This position might be purchasing and selling or selling and purchasing the same stock on the same day in a brokerage account. The buying and selling transaction together is also known as a “round trip.” The rule applies to all asset classes, including stocks, bonds, ETFs, options, etc. If you open a position and hold it overnight, it doesn’t qualify as a day trade. Also, an order will only count as a day trade once it gets executed.

However, there are exceptions to the rule. One is a long security position held overnight and sold the next trading day before any new purchase of the same security. Another exception is a short security position held overnight and purchased the next day prior to any further sale of the same security.

If the criteria mentioned above are met, the trader’s account will be designated as a pattern day trader (PDT) by the broker. A pattern day trader account is subject to specific trading restrictions and requirements.

What Are the Official Pattern Day Trading Requirements?

Day traders must maintain minimum equity of $25,000 in their margin accounts on any day they place day trades. It can be a combination of cash and securities, provided that their combined worth equal or exceed the minimum requirement. If a day trader’s margin account falls below the $25,000 mark, he would be restricted from trading until the sum is restored. If the maintained account balance remains below $25k, the freeze will end after 90 days. Then things start from the beginning again with the limitation of up to 3 day trades within 5 business days.

Day traders should always make sure to take into account any open swing or long-term positions in their accounts. If one is busy trading the stock markets and isn’t aware that he is losing money on open positions, the account risks falling below the equity requirements.

The buying power of pattern day traders is 4x the minimum equity requirements. In comparison, non-day traders only get 2:1 margin buying power.

If a day trader exceeds the buying power limit, he will receive a margin call from the broker. At that point, the trader would have to deposit additional capital to get their margin trading account back in line with the requirement.

The period for this is five business days. In the meantime, the account will remain restricted to day trading buying power of two times the maintenance margin. If the trader doesn’t deposit funds within the required deadline, their brokerage account gets further restricted to trading only its available cash. This restriction remains for 90 days or until the trader meets the margin call.

Once the trader meets the margin call, the deposited funds and eligible securities must remain in the account for two business days after the close of the business day when the deposit is required.

Pattern Day Trading Requirements at Your Brokerage Firm

While FINRA has clearly defined the PDT rule, some brokers rely on a broader definition or have tweaked its requirements. The reason is that FINRA gives registered broker dealer companies the freedom to shape and apply their own requirements, provided that the baseline rule is met. As a result, many brokers impose in-house maintenance margin requirements, exceeding that of the regulator, for example. The period for returning your account to compliance after receiving a margin call can also vary depending on the broker and be less than the five business days set by the regulator.

Furthermore, FINRA gives brokers the freedom to qualify a customer as a pattern day trader if it has a “reasonable basis to believe” that they will engage in such activities. One example of such a reasonable basis is if the broker has provided the customer with day trading training before opening an account.

That is why the best way to find out if or at what point you will qualify as a pattern day trader is to contact your broker and find out about their specific requirements.

History Of the Pattern Day Trader Rule

The minimum equity requirement in FINRA Rule 4210 was approved by the Securities and Exchange Commission (SEC) on February 27, 2001. It came as a response to the dot-com boom of the late 1990s when the activity that today qualifies as day trading significantly increased.

At the time, the dominating investment strategy involved:

  • Trading on high leverage with borrowed money within small accounts causes people to lose more money due to margin calls than what they had in the account
  • Buying shares at IPOs, capturing the immediate gains and selling the stocks afterward
  • Cross-trading between various ECNs and Exchanges

After the dot-com bubble popped, the risks of reckless day trading and manipulative trading strategies fell under increasing pressure from politicians and the media. As a result, the FINRA and SEC stepped up and intervened to protect the investing public by introducing the PDT rule.

What Is the Need For Pattern Day Trading Rules?

The rules effectively hold pattern day traders using margin accounts to higher standards than holders of cash accounts by requiring them to keep more significant amounts of cash and/or securities in their accounts.

This is because day trading bears risks for traders and brokers alike.

The most significant risk is the financial one. Even if all positions are closed by the end of the day, their settlement usually takes a bit longer. The minimum equity requirement gives the broker a cushion to comfortably meet any potential gaps left by the traders’ activity throughout the day.

Furthermore, these rules help keep trading risk within reasonable amounts by imposing a margin requirement based on the trader’s largest open position during the day. Some brokerage firms even choose to increase these margin requirements below what the regulator advises.

The PDT rule also protects public companies from abusing their shares with predatory practices. Without a day trading rule, market participants could have continued engaging in manipulative trading activities like the one mentioned above, causing volatility in the stock market.

Margin Account vs Cash Account

With a margin account, traders need to maintain a minimum of $25,000 in their account to day trade. With the margin account, they can trade on high leverage (e.g., $4 for every $1 they have, so $100,000 buying power with $25,000 in the account). Those who open a cash account do not fall under the PTD rule and can trade as often as they want but only position values up to the money they have in the account. For example, investors can trade $5,000 in a cash account with $5,000 in funds.

Now you might say, okay, let’s open a cash account, and that’s it since I’m absolutely okay with trading without margin/leverage. But here is the deal, the trade and cash settlement takes a minimum of 1 day. So that means that it is not realistically possible to day trade with a cash account because once one trade is made, it takes 1 day or longer until the funds are once available again.

When Will My Account Get Flagged as Pattern Day Trader?

Brokers usually flag accounts as pattern day trading automatically in a relatively short period, so if you have broken the rules for this, you must comply with the PDT requirements listed above.

Here is an example – suppose that you decide to purchase securities (let’s say six stocks) at once in your margin account. Then you change your mind and sell three of them in the same day. At that point, you have concluded three round trips (three times stocks bought – three times stocks sold). If you make one similar trade (1 roundtrip = buying and selling transaction) within the five business days, you will have four round trips, and your account will be flagged for PDT.

While it might appear exhausting to constantly make sure you are in line with the pattern day trader requirement, it is worth noting that some brokers ease the process of monitoring the available day trade buying power. Many platforms today have built-in features indicating the current day trade buying power and the amount of assets that can be day traded without incurring a margin call in the particular account. Once an account is locked, the available amount gets to $0.

In addition, some brokers also have day trade counters that make it easier to see how many day trades you have made in the current five trading day period. However, a day trader typically trades 20 or more times per day, so it’s sufficient to keep an eye on the account’s total balance. Day trading under the pattern day trader rule remains possible as long it stays above $25,000.

I’ve Been Flagged as a Pattern Day Trader – Now What?

The short answer is that you must adhere to the official requirements.

First, if you don’t have $25,000 in your brokerage account, you will be restricted from opening new positions and making further day trades until you deposit more funds.

What happens next depends on the broker and its policies. Many brokers have adopted pattern day trading restrictions that go beyond the scope of the official ones set by the regulator.

If it happens for the first time, brokers with more forgiving policies might decide not to impose their entire spectrum of restrictions. However, from that point on, your activities would most likely be watched for any consistent or repeat offenses. On the other hand, once a broker with stricter policies has flagged your account as a pattern day trader, you will have to comply with its rules and restrictions, even if you have done it by accident.

Once your account has been flagged for PDT, it will continue to be monitored even if you are no longer actively trading. This is because the broker will have “reasonable belief” based on your brokerage account prior history that you can, at some point, engage in such practices again.

If you have changed your trading strategy and no longer intend to day trade but buy-and-hold, for example, or if you believe you have been flagged as PDT by mistake, you should get in touch with the broker and explain your case.

Being flagged as a pattern day trader doesn’t mean you will remain one for eternity, though. Regulatory guidance on flag removals is relatively strict, but you may have the flag removed from your account once. In fact, with many brokers, you would be eligible for a one-time removal of your PDT flag and/or associated restrictions.

However, the PDT flag won’t be removed in case of repetitive offenses. Still, after 90 days, the pattern day trader flag gets removed, and it is once again possible to make 3 day trades within 5 business days with less than $25,000.


Wash Sale Rule

The wash sale rule is the second day trader rule we want to talk about in this article. First, the wash sale rule is only relevant to residents in the United States and was introduced to clarify the implications of wash sales to taxes.

While the pattern day trader rule needs extensive details to explain all modes of operation, the wash sale rule is kind of straightforward.

Let’s explain it with an example. Trader A typically holds positions in the longer term.

By the end of 2022, he held four positions:

  • 1,000 shares of Apple (up $50,000))
  • 1,000 shares of Amazon (up $25,000)
  • 1,000 shares of Google (up $25,000)
  • 1,000 shares of Gamestop (down -$50,000)

In 2023 he decides to sell all shares of Apple, Amazon and Google with massive gains of $100,000 in profit. Of course, he knows that he has to pay taxes for capital gains for this realized profit. While Apple, Amazon and Google shares were up pretty nicely, he also has 1,000 shares of Gamestop, and they currently are down -$50,000 (50%).

Trader A does not want to re-invest in Apple, Amazon or Google anytime soon, but he still believes in Gamestop and thinks that it will skyrocket at some point to make it a worthwhile investment.

So Trader A has an idea.

Why not sell the 1,000 shares of Gamestop for a loss of -$50,000 and immediately repurchase the shares on the same day with a day trade? It sounds simple, sell 1,000 shares of Gamestop market at the open and repurchase it a few seconds later. Trader A does not want to make the trade to make a profit with a day trade.

Instead, he wants to reduce the capital gains from +$100,000 (from selling AAPL, AMZN, and GOOG) to +$50,000 by realizing the -$50,000 loss from Gamestop. Paying taxes on the remaining +$50,000 capital gains is better than paying it on +$100,000 in profit. And since he repurchases Gamestop at a lower price, it might make him feel better to see the position grow from that point.

But, well, with taxes, it is like it is with taxes, right?

The SEC says that if someone executes a wash sale, then the realized losses can not be used to deduct losses from profits. So even if Trader A materialized the loss, he still would have to pay taxes on the +$100,000 profits.

How is a wash-sale defined?

The U.S. Securities and Exchange Commission states that a wash sale materializes when you trade or sell securities at a loss and within 30 days after or before the sale you:

  • Buy the identical securities
  • Acquire an option or contract to buy identical securities.
  • Acquire identical securities in a fully taxable trade

The IRS is pretty clear in its guidance, and it is important to contact a CPA to talk with him in detail about the implications and the best way to handle things correctly. The impact can be massive.

All in all, the wash sale rule makes it impossible in various ways to use day trades for tax optimization.


Uptick Rule

The uptick rule is the third and final day trading rule in this article. The rule was introduced by the SEC and is only relevant for short sellers. During the financial crisis, markets were wiped out various times, and various market halts happened. That was frequently caused by short sellers who sold more and more shares short, pushing the market lower and lower.

The uptick rule was introduced to reduce the downside momentum security can encounter. The uptick rule applies to all U.S. listed securities once they are 10% down for a day. Once the uptick rule is applied, security can no longer be sold short on or below the bid.

Uptick Rule Example

Netflix shares are volatile after an earnings announcement and open 15% down vs. the previous day close.

High frequency trader B wants to short Netflix shares to participate in further downside momentum. Without the uptick rule, he could simply sell short 10,000 shares of Netflix with a market order to get an instant fill on the sell order.

But now there is the uptick rule, and the rule prevents him from getting a fill on a short market order. What he still can do is enter a short limit order above the best bid and wait for an order fill for the limit order price. But instant fills are no longer possible.

So, if the Bid price is $100 and the Ask price is $101, he can use a short limit order of $100.01 or higher, but he can not sell with a limit at $100 or sell short market.


Day Trading Rules Summary

The pattern day trader rule might sound like a real headache at first, but it shouldn’t be. The rule is there with a purpose and has precise requirements – if you don’t break them, you simply won’t be flagged as a pattern day trader.

The rule is the key day trading rule everyone should be aware of and applies to U.S. accounts only. Maybe you are wondering if there is a chance to day trade without being flagged as a day trader. Fortunately, there is – check out my pattern day trader rule workaround guide for tips and tricks on valuable workarounds.

The Wash Sale Rule and Uptick Rule are two more day trading rules to keep in mind. Both rules only apply to some day traders, but the implications can be wide-ranging.


FAQ

Is pattern day trading right for you?

Pattern day trading is suitable for you if you have the needed capital and plan on trading actively. You should have sufficient day trading experience and high-risk tolerance to be able to properly handle the volatility, especially when trading on margin. Otherwise, sticking to infrequent trading or strategies with less-risky investment objectives might be better.

What happens if I day trade four times?

If you conclude four trades in a five days period (4 securities bought, 4 securities sold) and they constitute 6% of the total trades in your margin account for the period. Then the account will be flagged for pattern day trading. From that point on, you will have to adhere to the PDT rules and requirements of your broker.

About the author: Alexander is the founder of daytradingz.com and has 20 years of experience in the financial markets. He aims to make trading and investing easy to understand for everybody, and has been quoted on Benzinga, Business Insider and GOBankingRates.