Let’s talk about the Pattern Day Trading Rule. A lot of people and most new traders are asking questions like why is pattern day trading bad or illegal? Or stuff like that. The real thing is that pattern day trading is not simple, and it’s not illegal. But to get a full idea and understand why it’s not illegal, you must know what it is and how it works.
Day trading is a pretty popular type of trading, and it is not a secret that many of the markets where a day trader works are super volatile. In fact, in order to be a good day trader, you need to find stocks that are highly volatile. And due to this volatility, many people are losing money. To that volatility, add the buying power that leverage gives you. This is one of the main reasons that the government of the US says it’s risky and created the PDT rule, a way of regulation to protect investors.
This name can make day traders feel upset and uneasy. The pattern day trader rule is a FINRA regulation for a stock market trader that makes four or more day trades in five business days while using a margin account. So, basically, if you trade a lot using a margin account, there are some chances that your account gets flagged as Pattern Day Trading.
The PDT was initially approved in 2001 in order to protect investors from losing all their money. The concept behind it is pretty simple, FINRA wanted to hinder new investors from starting day trading and make them choose a hold strategy. This strategy consists and buying and holding a share of stock for months or years. Which seems to be less risky than day trading, and that’s exactly what FINRA wanted.
As I mentioned before, the pattern day trading rule is only applicable for margin accounts. Those accounts give you leverage, which means, you will have more buying power. For example, if you have a leverage of 5:1 and $1k in your account, this means that you can trade with $5k instead of $1.000.
It seems that FINRA thinks that trading with leverage is too risky. And it may be, with margins accounts you can win more money, but you can lose it a lot faster. The risk that this implies is the main reason why they need you to have at less $25.000 in your account. If you reduce this amount, the brokers will restrict you to only doing 4 trades in five days
What happens if your account gets flagged in the middle of a trade? Well, if you’re in a position after the four trades, you will need to wait for the five-day period to end in order to close that position.
The PDT applies only to trading accounts with margins that are under the regulation of FINRA in the US. The organization can’t regulate brokers outside the US.
You already know how it works, and you know the PDT rule is not illegal. The easiest way to avoid the pattern day trading rule is not to use a margin account. If you trade using a cash account, you would have any issue like this. You should not confuse this with price patterns or chart patterns.