If you’ve had any experience trying to trade with an account below $25,000, you’ve likely heard of the Pattern Day Trading Rule and wondered how you could avoid it. This rule can be a real nuisance for traders, especially those looking to learn who don’t want to risk too much initially.
Now, I’ll be the first to admit that the line between professional day trading and gambling can get really thin, really quickly, and that there is some merit behind this regulation.
That said, day trading is something that is demonized far too much and far too often these days. In effect, the Pattern Day Trading Rule can really hamper newer traders who are looking to gain traction in the market and in their accounts. What are some ways that people can avoid the Pattern Day Trader Rule?
What Is The Pattern Day Trading Rule?
For those of you wondering, to be considered a Pattern Day Trader (PDT), one must meet these requirements:
According to the Financial Industry Regulatory Authority (FINRA), “You will be considered a pattern day trader if you trade four or more times in five business days and your day-trading activities are greater than six percent of your total trading activity for that same five-day period”. Here’s the source for that quote.
You must also maintain a minimum of $25,000 in your trading account to make more than 4 day trades in a 5 day period. If you place more than 4 day trades in 5 business days without having a minimum of $25,000 in your account, your account will be suspended from being able to make any more day trades. You can still open and close trades. You just can’t open and close the same trade prior the closing bell.
To further clarify, FINRA defines day trading as follows: “Day trading refers to buying then selling or selling short then buying the same security on the same day. Just purchasing a security, without selling it later that same day, would not be considered a day trade”.
In other words, you could open a trade in MSFT while closing a trade that you held overnight in AAPL. Once you’ve hit the limit of 4 day trades in 5 business days, you cannot open and close a trade in the same security in the same trading day.
The Pattern Day Trader Rule applies to Stocks as well as to Stock Options.
How Can The PDT Rule Be Detrimental?
Most new traders start off with smaller accounts under $25,000. Most people don’t want to risk a lot of money when they’re first starting out. That’s logical. It makes sense.
Heck, most people don’t even have $25,000 to begin with that they can just throw into a trading account. However, how did Michael Jordan get so good at basketball? By taking a lot of shots and by being emotionally invested in what he was doing.
More Occurrences = More Experience = Faster Cultivated Skills
In order to become proficient at something, you need to increase the number of occurrences you have while also being emotionally invested in what you’re doing. For Michael Jordan, it was shooting free throws. For a trader, it’s placing trades. Now of course, a trading simulator is a way to increase the number of occurrences without risking real money, but that’s the problem. You won’t be emotionally invested.
A simulator does not simulate what it’s like to be trading live money. Here’s an article on weighing the pro’s and con’s of using a trading simulator. I’m not saying don’t use a simulator. You do what you think is best.
The more shots you take, the better you get and the more experienced you become. That’s not to say that you should blindly take trades for the sake of taking a trade and increasing your number of occurrences. That’s just dumb.
While the Pattern Day Trader Rule can slow the bleeding, it also slows down a trader’s development. What’s the solution here? I think in the future, regulators could make an effort to remove the day trading restriction, while lowering the leverage capabilities of smaller accounts.
Mathematically speaking, the lower the leverage the smaller the losses (and gains). To restrict a person’s ability to enter and exit trades is akin to removing liquidity, and that’s almost never a good thing.
It Puts The Trading Industry In A Bad Light
Having such restrictions on a person’s account can lead them to blowing up their account faster by trying to take too much risk to make up for the missed opportunities that a day might give.
If the situation allowed for traders to trade with very little leverage, but they could day trade to their heart’s content, I think the trading industry would be much more accessible to the majority of people. With easier access to making trades, there’s a possibility that people would be less reluctant to participate in the market. That’s just my opinion at the present moment. Take it for what it’s worth.
2 Ways To Avoid The Pattern Day Trader Rule
So now that we’ve established what the Pattern Day Trade Rule is, and my issues with it, let’s talk about some ways you can get around this regulation. These 2 ways are 100% legal. They’re just different ways of skinning a cat. Please keep in mind, I’m merely offering some light and not offering investment advice. What you do is your decision.
Trade In A Cash Account
A cash account is your standard type of account. It’s kind of like a checking account at a bank. A cash account differs from a margin account in that a margin account lets you use leverage. Here’s some of the difference between a cash account and a margin account:
- Minimum $2,000 balance required to open
- Allows you to sell short
- Allows you to use leverage (typically 1:4)
- Subject to PDT Rule
- No minimum balance necessary to purchase Stock
- Cannot sell short
- Cannot use leverage
- Not subject to PDT Rule
If you plan on using no leverage and only purchasing Stock, using a cash account can be one way to get around the Pattern Day Trader Rule. However, not being able to use leverage eliminates a lot of the benefits that day trading allows for. Is there a solution that allows for you to make unlimited day trades and use leverage? Yes.
Futures get a bad wrap. A lot of people argue that Futures are too risky and dangerous for the average investor/trader. While Futures may not be suitable for most people, we shouldn’t put a blanket statement on them. Futures are the most capital efficient products to trade that I know of. They have low initial margins, and benefit from different taxation structures.
Not only that, but some of the most liquid markets are in the Futures markets. The biggest reason that people get burned in Futures is that they simply overleverage themselves.
There’s a lot of brokerage firms out there that offer $500 intraday margins. With the large notional sizes of Futures contracts, that kind of leverage has a high probability of crushing you. Check out this article for a more detailed explanation of the math behind leverage and account gains/losses.
As I already mentioned, Futures benefit from a better taxation structures than Stocks. While you should consult an accountant, in most cases Stocks that are held for less than a year get taxed at a Short-Term Capital Gains tax rate. That means that you’ll be taxed in your standard tax bracket, just like you are for ordinary income. Stocks that are held for over 1 year are taxed at the Long-Term Capital Gains rate, which is about 15%.
Futures, on the other hand, are taxed at a 60/40 tax rate. 60% of your gains in the Futures market are taxed at the Long Term Capital Gains rate (15%), and 40% of your gains are taxed at the Short-Term Capital Gains rate (the current maximum is 39.6%, depending on your tax bracket). The maximum combined tax rate works out to about 28%. Again, be sure to consult with your account.
Taxes, liquidity, and leverage aside, Futures can be thought of as big Stocks. Aside from being a 24 hour market, Futures can be bought, sold, and shorted just like Stocks.
While I think trading a Futures contract on $500 worth of margin, for those who are looking for aggressive gains with under $25,000 in trading capital, trading Futures can be an excellent way to get around the Pattern Day Trading Rule.
If you’re looking to only play from the long side, without any leverage, then using a cash account be another way to benefit from short-term price movements.
What actually causes traders to blow their accounts? In my professional opinion, the answer involves too much leverage, low liquidity, and high volatility. Overtrading and getting “chopped up” are two separate things. If you’re consistently making money by making 100 scalps a day, I don’t see an issue with that.
Again I’m not giving investment advice with any of this… Just providing a perspective. Thanks for reading, and take care!