The PDT Rule
The Pattern Day Trader Rule
In short, this is an NASD & SEC rule that tries to limit the day trading activity of small traders.
Although you may not plan to day trade, be sure to read this, as the PDT rule imposes some restrictions to the small trader, even if you don’t day trade.
It applies to traders that buys and sells a particular security in the same trading day (day trades), and does this four or more times in any five consecutive business day period. If your broker detects that you did such trading activity, it will require that you maintain an equity balance of at least $25,000 in a margin account. If you can’t, your account is frozen for 90 days.
It is important to have clear what is a day trade. Our friends of Interactive Brokers show you some examples of what is considered day trades, and what not. Be sure to review what is not considered a day trade. Example: Buy 100 ABC shares on Monday, sell 100 ABC shares on Tuesday, and later the same Tuesday buy again 100 ABC. This is not a day trade.
Day trading rule applies for stock and options, but not for futures. In fact, futures and future options are not limited by the Pattern Day Trade rule. If you plan to day trade and don’t have the capital required as per the PDT rule, you may try to do that using Single Stock Futures (SSF). However, we advice not to do that, as SSF has the problem of having a wide spread (difference between ask and bid price), which can a big handicap when day trading.
Interactive Brokers has an interesting approach to avoid their customers to broke inadvertently the PDT rule: They provide you the information on how many day-trade you can do in the next 5 days, within the PDT rule. They even don’t allow you to execute the offending 4th day-trade. Once you acumulate up to 3 day-trades, they limit your account and don’t allow you to open a new position until time passes and the 5-day period have past. In fact, they apply like a soften pre-PDT rule, which blocks you for at most 5-days, in order to avoid applying the stronger official PDT rule, which blocks you for 90-days.
Ok, if you don’t plan to day trade… why is this important for you, as a small trader? Because the PDT rule have some practical effects related to the the way you set the stop offs.
Breaking the PDT rule
Although the PDT rule is though for preventing small traders to day-trade, a small trader may break the PDT rule during the normal trading. Look at the following example:
At 10:00 AM, you enter two trades for the volatile stock YYY and ZZZ, buying 20 shares of each at US$30 and US$31, respectively. As a disciplinated trader, you set their stop offs at US$28 and US$29. This is a bad day, and unfortunately, by 11:00, both stocks pull down and their stop offs are hit, and you automatically sold them. You are happy because the stop offs protected your capital: both stocks are trading now around US$25. However, as you bought and you sold two stocks the same day, they count as two day-trades, even when you were not actually day-trading.
The next day, as you never heard about the PDT rule, you try again with two stocks MMM and NNN, set your stop offs, and again, before noon both stop offs were triggered. These also count like two additional day-trades, so you now have accumulated 4 day-trades in two days, and by the PDT rule, you have to have US$ 25,000 in your account or you are prevented to trade by 90 days. And you were not day trading in the strict sense of the term.
Even more, IB pre-PDT rule will not help in this case. When the fourth stop off is triggered, IB trade execution validation rules will block the execution of the stop off. This is even worst, the stock may continue to go down, your stop off was not activated, and you cannot execute an exit from the position until the next trading day. Scary, uh?
The morale is that even if you don’t plan to day-trade, as a small trader you should be very aware of the PDT rule, as it limits your trading strategy.
Small Trader strategies
In the example above, you see how easily you can break the PDT rule and get in trouble. In the next parragraphs we provide some practical advise to avoid problems with the PDT rule.
|As a general rule, enter the trade (both the open position and the stop loss) as late on the day possible, preferable near the time of market close. If the trade is going to fail and the stop off is marked to be triggered, it is preferable this happening the next day, so the operation is not deemed as a day-trade.Some traders think that this is a bad policy as you are taking the risk of carrying a position overnight, and a gap up or down may happen, making the stop off activated in the worst possible conditions, and in this case the loss would be bigger than having the stop off activated the same day. The answer is that if that worries you too much, you should be day-trading. Day traders, by principle, never carry a position overnight, to avoid an adverse gap up/down.Gap up or downs tipically occurs due to unexpected news or intense rumors. You will never be free of that, if you carry a position overnight.
Nevertheless, you can do certain things to minimize that. For example, if you trade a post on an earnings anouncement day, there are bigger odds for a gap up or down the next day. Another sign of something unusual is happening is to see big volatility or untypical volume increasing by the end of the day. In those cases, this may mean that some information has been disclosed, but is not of public domain. A gap up or down is more likely to happen the next day.
|When trading options, entering the trade by the end of the day has the inconvenience that for the next day, the option price will be immediately decreased with one theta. As we recommend to trade options with theta near to zero, this should not be a problem. But, if you are playing near-to-expire options, this is a fact to have in mind before entering a trade near the end of the day.|
|Never open more than three positions on a single day. If you open 4 positions and all of them are stopped off, you will be punished by the PDT rule. No exceptions. Although thus guideline is necessary, it is not sufficient to avoid the PDT rule.Actually, this situation can happen frequently to the undisciplinated trader. Some beginner traders jump immediately into another trade as soon as they are stopped out of a position, frequently with less analysis that the previous trade. They feel they need to have the money on some move. If this happens frequently and compulsively, then there may be a gambling problem.But even if a trader do his homework in advance and have like 4 candidates to invest in, jumping in one after other due to being stopped out will activate the PDT rule. This leads us to the next, very important rule.|
|Have a track of the day-trades available for the day, and for the next 4 days. That is the maximum number of trades you may open every successive day. Have in mind that if you exhaust your 3 day-trades in a single day, you will not be able to trade the next 4 days.Interactive Brokers help on this, as they provide a counting on how many day-trades you have available for a 5-day horizon. But you can do this yourself by hand.|
|Plan your trades to be done spaced evenly along a week. This the better policy. If you plan to do one trade at most every other day, you will never be catched by the PDT rule.In fact, this works perfect with the healthy advice of do not overtrade and allow you time to do your research, identify opportunities, plan your trades and finally, trade your plan. This every-other-day trade policy will force you to devote time to the pre-trade activities.Of course, you may need to adapt this rule to the conditions of the market, or the event days of the stocks you are following. For example, you may need to advance or postpone the day you intend to trade due to an earnings announcement.|
|Have in mind that the reentries are not day-trades.For example, you buy a stock on Monday, and the stop off is triggered on Tuesday morning. However, some hours later the chart shows that the pullback was a momentary reaction and the price is clearly resuming the trend you initially anticipated. You want to reenter the trade, but don’t want to “use a day-trade” for that.This shouldn’t stop you. You can reenter and it is not considered a day trade. Of course, if the stop off for the reenter trade is hit on Tuesday, it does count as a day trade.|