The world of finances, business, and especially trading is a very complicated one for many reasons, especially for the newcomers who are still inexperienced but eager to make it big as soon as possible. There are many rules that dictate how you should behave and what moves you are allowed or not allowed to perform.
It is surprising that even the most experienced traders fall between the cracks and make a mistake or two, breaking the rules and having to deal with them. One of the most important rules to know about as well as to try not to break is the PDT rule. If you are an active member of the trading game, you have probably heard a lot about it.
There is a chance you know something about it but that is nearly not enough. To truly be safe and not make the mistake many do, you must know a lot more about this rule, why it exists, what it is, and what happens if you ever break it. Lucky for you, that is exactly what we are going to talk about in the article here. To know more, we advise you to visit thedaytraderchatroom.com.
What is It?
PDT stands for Pattern Day Trader, and it is a very common reason for frustration both among beginners and among experienced members of the trading industry. It exists in order to discourage and prevent excessive and unnecessary trading. It is rather simple in theory really, as it aims to prevent making four or more trades on something within five business days.
Buying something, then selling it, and then repeating the process by buying it and selling it again during five business days end up in breaking the rule and it is something traders should stay away from and never do. Since the game of trading is volatile and aggressive by nature and everyone is trying to make the most out of their every deal, traders naturally want to get the best deal based on the changes in prices.
This sometimes leads to too much buying and selling on a single entity, resulting in the PDT rule being broken. It is a smart system that was introduced to protect everyone, including the market itself, from too many deals that would make it impossible to do business.
Know About the Day Trade?
Alright, so the rule contains the term “day trade” in its name, so what does that mean? Now that you know more about the rule itself, let us determine what it protects and when you can potentially make it yourself. A day trade is when you first open and then close a security position during the same day. The opening is buying while the closing is selling, to use the broader sense and easier everyday language.
Doing this and opening and closing on the same day is also called a round trip, for obvious reasons. The next thing worth discussing is what security positions are. These are the things you buy and sell, for example, stocks, bonds, and ETFs. Different things are tradable and any one of them is called security. Regarding the term “same day,” it refers to the time during which trading is possible during a workday.
Those who make four or more day trades during a course of five days are referred to as pattern day traders. There are different types of day traders out there, two of which are the most important. The first is called self-identified day traders and know full-well what they are doing as it is what they intended.
They have a minimum of $25,000 in their trading account, which means they are exempt from the rule. The other type is the actual violators, people without the minimum amount in their accounts. In addition, the trades that occur must make up for 6$ of all account activity when day trading occurred.
What If I Break It?
So what would happen to you if the rule is broken unintentionally? As mentioned, it is very easy to break this rule and it happens a lot more than it should. Basically, if you have under $25,000 and trade on the same security in five business days, you violated the rule. What is more, if you are a pattern day trader already but you end up with less than $25,000 during a trading day, you are also in violation. Then what?
Each individual brokerage enforces the rule, so certain brokerages have stricter policies and punishments than others. It greatly matters who you are with when talking about the outcome of you breaking the PDT rule. There are things that are almost always expected to happen and can be said to be the outcome of a broken PDT rule.
First of all, the brokerage issues a margin call, practically a request for the trader in violation to deposit additional funds into their account so that the minimum required balance is restored. They have business days to comply. During these five days they will only be able to close (sell) with their account. They cannot open (buy) new trading positions and securities.
If the margin call is left unmet, the true punishment arrives in the form of a frozen account. The freezing lasts 90 days and there can be no trading activity with the margin account in question. The trader could be allowed to unfreeze the account if they manage to restore the $25,000. In some situations, using the cash account during the 90-day penalty is allowed.
We again have to mention that every single brokerage is different and they could take different action towards the solution of this problem. The simplest workaround against this rule would be to have multiple brokerage accounts. While many simply advise against it and discourage it, traders still want to try it and often come to regret it. Using the cash account for long is not always an option either, so to stay safe and secure your financial well-being, do not overtrade.