May 24, 2011 at 10:19 am | | Comments 10

Not a Pattern Day Trader?

The phrase ‘Pattern Day Trader’ has this negative connotation to it which scares a lot of people unnecessarily.  It conjures up images of high risk or compulsive behavior, neither of which are entirely accurate.

Many traders have asked me about having the Pattern Day Trader designation out of concern that it puts them in the same light as ‘perpetual liar,’ or ‘drug addict’ or any of the corrupt individuals found on the no-fly list.

Nonsense! Don’t get spooked by a label.

The Pattern Day Trader designation is simply a category for an account, and therefore doesn’t mean you have any sort of a repetitive disorder!

What It Is

The SEC implemented this classification for accounts, and brokers are required to comply. The restrictions imposed on those without the designation are not a plot against you – your broker is simply enforcing what they’re required to do.  Supposedly, the SEC put the PDT rules into effect to protect those with smaller accounts from the ‘high risks’ associated with day trading (as opposed to those ‘other’ high risks found in longer-term ‘investments’ or crossing the street at a busy intersection).

* Personally, I think attempting to pick the next MSFT and holding
hoping for decades it works out is higher risk than the astute day
trader who’s continually limiting his losses, but I digress…

The Pattern Day Trader distinction carries with it two requirements, which are that the account is a margin account, and that it maintains a $25,000 equity balance.  Once those are met, you’re free to trade as often as you want, as well as have the benefit of 4:1 intraday margin at your disposal – nice for those who know how to use it.

Those without this account designation, however, have some restrictions.  Primarily, they’re unable to make 4 or more round-trip trades in a 5-day period.  That really cramps the style of the would-be active trader who has an account below the threshold, and it’s easy to argue that there’s HUGE risk in having your account frozen when the market is on the move.

Get Creative

If you’re one of the traders currently limited in your activity by the Pattern Day Trader restrictions, take heart.  You have choices.

The most obvious is to fund your account enough to bring it past the threshold. That’s not an option for everyone, but arguably, even if you didn’t intend to fully utilize the capacity of the account (or day trading buying power which comes along with it), you’re at least free to trade as you see fit with no restrictions.

Supposing that’s not a viable option, there are others, so let’s explore a couple.

* Focus on longer timeframes. There’s nothing that says you can’t trade – only that you can’t trade very frequently! That shouldn’t prevent you from zooming out a bit on your timeframe from multi-hour trades to multi-day trades, ie: swing trading.  That approach certainly has benefits – not only does it allow you to sidestep much of the intraday noise and seek out larger moves, but it will of course mean fewer transactions. The lack of churning will also cut down on commissions, which is a nice fringe benefit.

* Consider trading futures. Futures are leveraged, but for the e-mini Nasdaq 100 or S&P 500 futures contracts, margin requirements are pretty low.  Futures are also not restricted to the Pattern Day Trader, so activity isn’t limited.

* Look at your options. While the Pattern Day Trader rule still applies to options, one element which many don’t consider is the turnover of capital within smaller accounts to make room for a new equity position.  For example, if you’re holding a stock which you don’t necessarily want to dump, yet see another you’d rather have, most likely you’ll exit the old in favor of the new (supposing your account doesn’t have enough equity to hold them both). With options, however, smaller amounts of capital are needed to control an equity position, thus allowing you to have positions in both.  Options of course expire, and there are other risk factors to consider if you have no experience trading them, but they do offer an alternative to an either-or equity stance.

The bottom line is that even if you’ve been slapped with the Pattern Day Trader designation, there are ways to be effective without simply buying and hoping.  As in many endeavors, a little creativity goes a long way in trading.

Trade Like a Bandit!

Jeff White
Producer of The Bandit Broadcast

Are you following me on Twitter yet?

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  1. This rule, ostensibly designed to protect small investors from risk, has actually caused me a fair amount of harm. Several years back, I realized that I both wanted to do some active trading and NEEDED to if I ever hoped to achieve better than mundane performance. But since it was new to me and there was a learning curve, I chose to apply just 10 percent of my investment capital to the endeavor.

    That meant opening a small account that was funded under the day trading threshold. And although the strategy I settled on was swing trading — the intent was to hold for a few days to a few weeks — there were a number of occasions when a profit target or stop loss was reached the same day as entry. Instead of letting the price action be my guide, I had to factor the pattern day trader rules into my decisions. Often this led to bigger losses or to giving back gains.

    It also led me into the e-mini markets, as suggested here, as a way to hedge and to avoid the rules. But the leverage and intraday volatility in these markets was not necessarily my friend. To keep risk manageable I had to place stops close to the market. Naturally, they kept getting taken out, and I churned the account and racked up commissions.

    I never did get manage to trade that account above the threshold. What happened ultimately is that I applied my active trading strategy to my main account — probably not the SEC’s original goal. But without the pattern day trader restrictions in place, the strategy, by and large, has been successful.

  2. Hey David, I think there are probably quite a few like you who have noticed more harm than good from the implementation of this by the SEC. But, it’s been there a few years now and hasn’t gone away, so I figured I’d put out a few ideas for those who are dealing with it on how to creatively allow themselves a few more opportunities. Thanks for stopping by and sharing your thoughts!

  3. Jeff: Nice article. Although I now have much more than the $25k minimum for day trading, there was once a time that I did not. A way to avoid the pattern day trade was to scan for stocks with good setups near the end of the day and purchase them immediately instead of waiting for the next day. This worked very well in most cases and allowed me to sell the next day on a move up or down without having to be concerned with the PDT rule.

    Of course, there were times that this did not work out, but I found that many, if not most, good setups will at least open up the following day.

  4. Steve, thanks for your comments! That’s still not a bad way to trade actually, as I would suspect you can capture some gaps by doing that on occasion.

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