If you’re a day trader, you’re likely well aware of the pattern day trader (PDT) rule, which imposes minimum balance requirements on traders who make a lot of transactions in a margin account.
The Financial Industry Regulatory Authority (FINRA) and the SEC are working on relaxing some of those requirements. Below, an overview of the rule as it exists today, how you can avoid it, and what to expect from the upcoming changes to it.
What is the pattern day trader rule?
FINRA currently defines a pattern day trader as someone who, in a margin account, “executes four or more ‘day trades’ within five business days, provided that the number of day trades represents more than six percent of the customer’s total trades for that same five business day period.
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This effectively means that some investors who place a lot of long-term trades but do a little bit of day trading may be exempt, but the opposite may also be true — if you’re placing only a handful of trades each week but the majority are day trades, you may be considered a pattern day trader.
(This is the minimum, industry-wide criteria for identifying a pattern day trader. Individual brokers may have broader criteria that define more users as pattern day traders; it’s worth reading the fine print for your brokerage account to see how they define the term.)
Under FINRA rules, pattern day traders must maintain a minimum account value of $25,000. This gate keeps a lot of beginner, small-balance investors out of day trading, by design, to protect them from the substantial risks associated with it. The minimum was implemented in 2001, in the aftermath of the dot-com crash, when many retail traders suffered significant losses trading overvalued tech stocks.
The scoring formula for online brokers and robo-advisors considers more than 15 factors, such as account fees and minimums, investment choices, customer support, and mobile app capabilities. This comprehensive evaluation helps determine the overall rating given to these financial platforms.
Exploring Day Trading on Robinhood and Cash Brokerage Accounts
Recent research revealed that the average 20-day return on stocks traded on Robinhood was -4.7%, indicating that a significant number of short-term traders end up with losses.
In contrast, long-term investments in index funds have shown more consistent returns. For example, the S&P 500 index has an average annual return of around 10%.
For those interested in day trading without the constraints of the PDT rule, switching to a cash brokerage account can be a solution. Margin accounts, which allow borrowing money for investments, are subject to the PDT rule, while cash brokerage accounts do not have this restriction.
Drawbacks of Cash Brokerage Accounts
It’s important to consider the limitations of cash brokerage accounts. Unlike margin accounts, trades settled in cash accounts may take up to one business day for the proceeds to reflect in the account, restricting immediate reinvestment.
Furthermore, executing same-day buy and sell transactions or advanced trades like short sales may require margin capabilities, which are not available in cash brokerage accounts.
While these limitations may hinder certain day trading strategies, using a cash brokerage account can still be an alternative for those looking to engage in frequent stock trading without the PDT rule restrictions.
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