So, you wish to be a day trader? That sounds like a great idea but you definitely need to have a strong understanding of the rules and regulations that would apply. Small traders might find the PDT (Pattern Day Trader) rule a major restriction when trading.
So, what can be done about it? This is exactly what I aim to show you in this article. We will see some stock trading strategies and the merits of each one to help you decide which route you should take.
Understanding Day Trading
Before I explain the PDT rule, I’d like to talk about day trading briefly. A day trader is one who utilizes price movements within the day through both long and short trades. The day trader will close his traders before the trading day ends and not keep his positions open overnight. A day trader typically works by examining stock prices and entering and exiting at a rapid pace to earn small profits all along the way which can quickly add up.
As you can guess, there are no statutory requirements for someone to be called a day trader. It all depends on the number of times you trade or the trading frequency.
What tools does the day trader use? A day trader spends a lot of time every single day using technical analysis techniques. He is mainly into analyzing price action— the movement of the stock price as a function of time. A day trader will be exceptionally good with technical analysis and have an inherent ability to manage stress really well. There’s a lot happening by the minute and the day trader has to stay on top of the trends as stock price varies. As you can see, volatility is the day trader’s friend. So is liquidity.
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Pattern Day Trading and The PDT Rule
There’s a difference between a day trader and a pattern day trader. A day trader who makes at least 4 trades during a period of 5 days and with the additional requirement of the day trades exceeding 6% of the total trading activity in a margin account during this 5-day period. What if you do not meet this requirement? Even then, the brokerage firm you are associated with can recognize you as a day trader.
Thus a pattern day trader is a day trader with an additional requirement on the number of day trades which must be met to qualify. This is where the PDT rule comes in.
- Now, once a day trader is deemed a pattern day trader, FINRA (Financial Industry Regulatory Authority) requires him to have a minimum amount of $25,000 in his brokerage account. This is where the trading activity occurs. It’s not essential for the entire $25K to be in cash— eligible securities are also acceptable. If you’re wondering why FINRA has this additional requirement in place, it’s because this helps reduce the risks that are inevitably linked with day trading.
- FINRA clearly states that this is the minimum equity that must be maintained before day-trading activities can commence.
- The moment the equity falls below the $25,000 mark, the pattern day trader will have to abstain from any day trades until the time the account has sufficient balance.
- Brokers usually lock the account of the day trader as soon as the PDT rule is violated. Each broker has its own lockout period which could last from 1 to 4 months.
The PDT rule was initiated for protecting the interests of new traders who could easily mess things up if they weren’t careful enough. There wasn’t a rule to protect inexperienced traders in the day trading space which was the main motivation behind this rule.
You will have understood that this equity requirement can make things complicated for small traders who do not have an account of the order of $25,000. Such traders can only undertake fewer day trades in a 5-day period.
You should also read our page on technical analysis tools such as Bollinger Bands which conceal remarkable insights that you can use when trading.
How to bypass the PDT rule
You might think it’s difficult to get around the PDT rule legally. However, it’s much easier than you think if you know the right strategies.
- You can restrict the number of day trades which will automatically disqualify you from the PDT rule.
- Some experts recommend opening multiple accounts with different brokers. You can then undertake multiple day trades within a 5-day period. However, there’s a catch— you will need to arrange to file your taxes accordingly if you have multiple accounts. Even though this technique is perfectly legal, you might have to put more time into tax preparations.
- Swing trading might be a more lucrative option to consider too. Swing trading will involve maintaining your position for a time frame spanning more than a day. The holding period can last from a few days to weeks. This is not only a way to avoid the PDT rule but will also keep the stresses associated with day trading at bay. This is not to say that swing trading is less risky, though!
- You can try choosing a foreign broker. Many foreign markets have less strict minimum equity requirements than the US.
- The rule can also be avoided by using a cash account. However, you should know that day trading in such a cash account is typically prohibited. A way to get around this is to ensure that the Regulation T of the Federal Reserve Board, particularly the free-riding prohibition is not violated by the traders, in which case day trading using a cash account is permissible.
- You can also choose to trade in a different market altogether. Consider the forex and options market for example. The capital requirements of many markets could be significantly lower.
Each approach above has its own share of pros and cons and you will be in the best position to decide the best way forward to trade without the PDT rule in place.
I would like to particularly draw your attention to the suggestion of practicing swing trading and other trading styles instead to get around the rule. In the next section, we will explore these trading styles in more detail.
Worried About PDT Rule? Consider This Trading Strategy
We discussed how swing trading is a great way to bypass the PDT rule in the previous section. Swing trading is a strategy in which a trader will hold onto an asset for typically several days. The idea is to make profits when the price moves favorably.
As you can see, a swing trader holds his assets for a longer time frame compared to the day trader. However, unlike an investment strategy that buys and holds for several months or even years, swing trading does so for months at the maximum.
You should also consider swing trading penny stocks which are cheap and hold interesting possibilities. Actually, penny stocks go really well with swing trading. Penny stocks operate in volatile conditions which opens a whole new world of opportunities for swing traders who can realize massive profits in a short interval of time.
Penny stocks are usually considered to be those that are valued at or below $5. You will thus be able to buy lots of stock at low prices. These are typically issued by small companies and can be very promising indeed. Of course, they carry risks since there is a degree of speculation involved. Look out for penny stocks that have good volume and fewer outstanding shares.
The Pattern Day Trader (PDT) rule requires qualifying day traders to maintain minimum equity of $25,000 to be able to make more than 4 trades in a 5-day period. However, many small traders, especially those just starting out might find their trading activities being limited as a result of this rule.
There are several ways to bypass the PDT rule, as I pointed out above and you should consider swing trading as a great alternative to make profits. Offshore brokers might also be worth considering. A simple way that does not involve any complexities at all is to simply limit the number of trades.
Whichever option you choose to go with, I recommend checking out the Raging Bull page on technical analysis tools which shows you how you can use these tools when creating a profitable trading strategy. Remember, technical analysis is a powerful skill which every trader – beginner or professional – should master.
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