Day Trading Rules
If you’re going to be a day trader, one of the most important things you must understand in the stock market world is the pattern day trader rule. But besides the PDT rule, there are various day trading rules you should be aware of.
See Also: Free Day Trading Guide for Beginners
Day Trading Rules
1. Patter Day Trader Rule
The FINRA (Financial Industry Regulatory Authority) clearly defines the pattern day trader rule (PDT Rule). Traders who execute four or more day trades within five business days in a margin account fall under the definition of a pattern day trader and violate FINRA Rule 4210 if the account’s total value is below $25,000.
If you are trading stocks in the United States and open and close a trade during the same session, that is considered a day trade. So, you can buy as often as you want per day, but for every trade you close, one combination of opening and closing transactions counts towards the PDT rule definition.
To day trade continuously without limitation, you must have equity of at least $25,000 and a margin account.
If you violate this rule, the broker will lock you out of trading for 90 days.
Still, if you increase the total account value once again above $25,000, you can freely day trade again.
An important aspect to remember is that even if your account gets locked, it is only for new opening transactions. So, if you have existing positions in your portfolio (long or short positions), you can close out those positions at any time.
However, once the rule is applied to your account, you can not open new long or short positions.
Why the PDT Rule Was Implemented
Even though it is a bit restrictive, there are reasons for this regulation and restrictions on traders. Initially put into place on February 27, 2001, the SEC approved amendments to existing rules for margin requirements on day traders.
The SEC sees active trading activities with a low trading capital as much riskier than buy-and-hold strategies. There are quite a few complaints about this rule, though, mainly due to the restrictiveness of the ability to day trade.
- Some traders consider this to be overbearing and will try to trade with an offshore brokerage account.
- There are also complaints that it is essentially a “poverty tax” on those who do not have $25,000 available.
Pros and Cons of the Pattern Day Trader Rule
On one hand, there are various pros when it comes to this rule.
- The rule protects small traders and can convince newer traders to take their time and learn how to trade before doing the riskier intraday trade systems.
- The PDT rule lets investors consider long-term investing to consistently grow wealth (on average more than 10% per year).
The cons of this rule typically focus on restricting freedom for the trader.
- Ultimately, the $25,000 barrier is difficult for many people, and the amount of $25,000 appears to be chosen randomly.
- Investors might consider investing in even riskier assets like futures markets or currency markets since the PDT rule is not applied, but it is riskier because the leverage is even higher with those assets.
PDT Rule Examples
Szenario 1: Mike goes long GS for $325.20 on Monday at 10:00 AM. During the same session, he sees the stock drop and gets out at $320.20 at 11:30 AM. This counts as a day trade.
Szenario 2: Susan decided to short BAC on Monday at 10:30 AM. News that’s very bullish for the stock comes out and is up $10. Susan closes the trade at 2:30 PM that same session, covering her short. This counts as a day trade.
Szenario 3: Michael has been in a long position with JPM since Wednesday. On Thursday, he decided to add to his portfolio by going long WFC. The market tanks due to geopolitical concerns, and his stop loss gets hit in both stocks.
The WFC trade ends up being a day trade, but the JPM trade has been on for more than one session, meaning he only has one day trade.
Important: Partitial fills count as day trades if the partitial fill of the closing transaction happened on the same day the position was entered.
PDT Rule for Margin Accounts vs Cash Accounts
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 at least 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 available again.
Pattern Day Trader Rule Workaround
Some traders use pattern day trader rule workarounds.
2. Uptick Rule
The SEC introduced the uptick rule, which 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’s 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 (PDT rule) and uptick rule are essential day trading rules that traders should consider before starting. It is crucial to abide by those rules to comply with regulations.
Those rules apply only to U.S. markets, and other countries have different regulations. Inform you about the latest regulations and contact your tax advisor for further clarification.