Day trading is a methodology used in financial markets that involves buying and selling the same security on the same day. It is often considered a high-risk, high-reward technique, generally indicated for experienced traders with advanced knowledge of trading strategies, such as scalping, and managing drawdowns in trading. According to the FINRA, a trader must maintain a minimum of $25,000 in their brokerage account before any day trading activities begin.
The FINRA established the Pattern Day Trader rule as a result of the dot-com bubble of 2000, when the market rallied due to the adoption of the Internet and explosive growth of tech startup stocks between 1995 and March 2000. Many inexperienced retail traders leveraged margin accounts to day-trade volatile stocks, resulting in margin calls and huge financial losses when the market finally collapsed by the early 2000s. Aiming to protect retail traders and brokerage firms, the FINRA and the SEC implemented the PDT rule to ensure only those with sufficient capital could engage in higher-frequency trading activities like day trading.
The reasoning behind the Pattern Day Trading rule is legit. It mitigates risk and reduces the likelihood that both traders and brokerage firms will incur unsustainable costs. However, it can still limit trading opportunities for small account traders, propelling the need for strategies to avoid being flagged as a pattern day trader.
Pattern Day Traders: Who Is Subject to the PDT Rule?
The PDT rule applies mostly to traders using margin accounts with less than $25,000 in their trading account who execute four or more day trades within a period of 5 business days. A margin account allows traders to borrow money from their brokers to increase their purchase power, allowing them to profit big, but also increasing risk exposure.
If a trader with a trading account balance of $10,000 buys and sells stocks on Monday, Tuesday, Wednesday, and Thursday sequentially, their account will be flagged as a pattern day trader by their broker. As soon as they’re flagged, they must maintain a minimum balance of $25,000 to keep day trading. Once an account is flagged, it tends to remain so. It is relevant to note that pattern day trading rules are limited to stock trading and equity options trades.
Consequences for Violating PDT Rules
If, after being flagged as a pattern day trader, the account’s balance remains below the 25k threshold, the account is frozen for 90 days, and the trader cannot make any further trades. Some brokers may offer the opportunity to reset the account’s flagging as PDT, but the account may face even harsher measures if flagged again, including suspension.
Overall, the policies vary from broker to broker. Some may even be more strict than the FINRA’s rules. They could flag a trader with less than four trades if they consider the trader to be incurring excessive risk. Depending on the broker, the flagged trader can request a removal of the PDT flag if they refrain from day trading for 90 days. The decision, however, belongs to the brokerage firm, and a request is not a guarantee that the account will go back to normal.
Avoid the PDT Rule: Getting Around Limitations and Restrictions
There are five main methods to avoid PDT restrictions. Each method comes with its own set of strengths and challenges. Those workarounds allow you to maintain flexibility without needing a minimum balance of $25,000. Depending on your capital, experience, and trading style, you can find a method that suits you.
Open a Cash Account
Cash accounts allow traders to trade stocks using their own money, without borrowing funds from the broker, making them essentially exempt from the PDT rule. Differently from margin accounts, which offer leverage to amplify purchase power, a cash account restricts traders to trade with the cash they have available.
Essentially, traders are free to day-trade as much as they want to, but their profits—and risk—will be significantly lower than that of a margin account. It is important to remember that another con of cash accounts is the T+2 settlement rule, where traders have to wait two business days to have full access to the funds from a trade. In practice, if you buy and sell a stock on Tuesday, the funds will be settled by Thursday.
Using Different Broker Accounts
Using multiple brokerage accounts is a workaround to increase the number of intraday trading by distributing capital across several margin accounts, each with its own five-business-day limit under the PDT rule. If you only have $10,000 to day-trade, you can open four accounts with $2,500 each and diversify your trading activity across these accounts. This is a smart way to avoid the pattern day trader flag, allowing you to day trade three times a week with each account.
The downsides of this strategy, however, are that some brokers have minimum deposit requirements. Some require $2,000; some require more; others less. Besides that, managing multiple accounts at the same time is more complex than it seems. Once you have a bunch of different accounts, you will have to monitor positions on each one of them and keep track of commissions, fees, costs, and taxes.
Trade Forex and Other Market Not Under PDT
As previously mentioned, the PDT rules are limited to stock trading and equity options. Traders are effectively free to engage in futures trading, crypto trading, and forex trading. With forex, very little money is needed to start, usually around $500, and leverage is as high as 50:1. Futures trading, on the other hand, might require somewhere around $1,000 to $5,000 per contract, with an increase in volatility and risk, which gives a lot of room to profit from price action. Crypto can be traded on platforms like Coinbase, and it is totally exempt from PDT rules but requires a lot of research into different market behaviors.
Each one of these markets comes with its own complexities. Forex is open 24 hours a day and requires a lot of macroeconomic analysis, beyond technical analysis. Futures demand a deep understanding of commodities and indices. Crypto, on the other hand, is highly speculative and requires a lot of study into different coins and their uses. It is also a good idea to avoid crypto if you’re prone to FOMO—fear of missing out—as many coins tend to have explosive gains only to go down to near $0 as fast as they rallied.
Move From Day Trading to Swing Trading
Unlike day trading, swing trading is a methodology based on holding positions for days or weeks, completely avoiding the PDT rule, focused more on intraday action. Swing traders are more focused on capturing price swings over a longer period of time, usually relying on technical analysis and chart patterns to identify entry and exit points over longer timeframes.
Adapting to swing trading is not as hard as it seems. Instead of focusing on fast-paced price swings, you focus more on daily and weekly charts. Studying the basics of swing trading can help you do a smooth transition.
Some pitfalls of swing trading involve the risk of overtrading and failing to set stop-loss orders correctly—either positioning them too far away or too tight to the entry point, among others. There is also a much slower pace to realize profits, which can be a bit frustrating for those more used to the fast, quick dynamics of day trading.
