Day traders will end up getting flagged as a “pattern day trader” after executing 3 round-trip trades in a 5 day business period. This will cause your stock account to be forced out of margin and can be infuriating for new stock traders. Many people ask why the PDT rule exists; well here are the 3 reasons why it does.
There are 3 reasons that the pattern day trader rule exists for U.S investors. First, the PDT rule exists to limit volatility in the market. Second, the PDT rule was designed to limit credit risk to brokerage firms. Third, the PDT rule was created to limit the market’s exposure to high-frequency trading.
For many investors, the PDT rule will cause anger. This is because if you are flagged as a PDT you will be unable to execute any day trades for 90 days! Imagine that you are a professional day trader who now can’t earn any money; naturally, you might be a bit upset.
At ChronoHistoria I teach people how to trade and invest like the pros on the street. Let’s jump right in; here are the 3 reasons why the PDT rule exists.
Reason 1: The PDT Rule Exists To Limit Volatility In The Market
A major reason why the PDT rule exists is to limit total volatility in the U.S stock market. It is no coincidence that the U.S SEC implemented the PDT rule during the height of the 2001 dot-com bubble.
Since the early 1990’s more retail traders than ever have been able to manage their investments with the help of computers and online trading. For the first time in human history, the average person was able to place an order directly to a broker at an exchange over a computer.
Almost overnight an entire business model of online brokerage services started popping up. Everybody and their mom could open a stock investing account and invest in the latest and greatest stock. Companies knew this and started to spend huge amounts of money on advertisements for novice investors to buy their stock.
From 1999-2002 retail investors began to pile into the stock market and put their money behind startup online companies that promised huge returns. Each company would promote higher returns on investment and the retail traders would flock to their stock. Imagine 10-15 million people all buying and selling the same stock within a day.
Naturally, this dramatically rose total volatility in the markets. The SEC had to restrict these day traders from crashing and pumping every company that had a low float. As such in April of 2001, the PDT rule was created to limit how fast retail traders could move their money around the market. This pushed retail traders to instead invest in large new ETFs which promised stable returns; this dramatically reduced total volatility.
As such, the first reason the PDT rule was created was to help prevent the rising mass of retail traders from crashing the market due to the increasing volatility that came with online investing.
Reason 2: The PDT Rule Was Designed To Limit Credit Risk To Brokerage Firms
The second reason why the PDT rule exists is because of the risk that retail traders and margin posed to brokerage firms.
Any stock buy or sell will take around 3 days to settle across all stock brokerage firms. This is because the stock purchase has to be verified by the U.S SEC, exchanges, and finally the brokerage firm itself. This means that under normal circumstances you will have to wait 3 days before you can use your money to trade again.
To get around this problem brokerage firms began to offer margin loans to retail traders in the mid-1990s. A margin loan is where the brokerage firm will allow you to trade with their money until your funds have settled 3 days from the purchase. Now you can buy and sell everything at a moment’s notice. This was the birth of day trading.
However, in a margin account, the brokerage firm is at risk for the action of the retail trader. Sure, if you blow up your margin account and owe the brokerage firm thousands of dollars they will issue a collection on your account. However, at the end of the day, the brokerage firm has to pay the final holder of the stock purchase.
Without the PDT rule in place, retail traders could effectively gamble their money away and then close their margin account. The brokerage firms would be liable for any and all financial damages since they issued the margin on the retail trader’s accounts.
Now imagine that 30 million retail traders entered into a bad position and now each owe $10,000 to a couple of brokerage firms. Most brokerage firms simply did not have that cash on hand and would have to either take out a massive loan from a bank or go bankrupt.
As more and more retail traders went into debt to the brokerage firms and banks this would have created a massive amount of risk in the U.S economy. This would have been a massive problem had the SEC not put the PDT rule in place in 2001.
As such the second reason why the PDT rule exists is to limit the risk of retail trader margin defaults to the brokerage firms.
Reason 3: The PDT Rule Was Created To Limit The Markets Risk To High-Frequency Trading
For the past 40 years, the SEC has been in a battle with computer high-frequency trading. The third reason why the PDT rule exists is that during the 1990s and early 2000s HFT was coming to dominate and make millions off taking money from retail traders.
The SEC in 2001 was beginning to notice the risk that these high-frequency trading computers posed to the market. This problem was becoming even larger once the SEC realized that anybody with a grasp of statistics could essentially crash the U.S economy using a computer algorithm.
These crashes are called flash crashes and they happen when a variable in a computer algorithm causes an entire portfolio to sell instantly. This will cause increased volatility which can cause other algorithms to dump their holdings as well. This creates a chain of computer algorithms all dropping their investments as volatility rises.
Today the only entities that use HFT successfully are large hedge funds and investment banks. This is because to build an HFT model today you will need a ton of resources. The talent, capital, and most importantly infrastructure needed to make it impossible for the average person to build one themselves outside of extremely rare situations.
The PDT rule prevents retail traders from implementing these HFT models themselves. While this is unfair to the individual trader it makes sense when you factor in that if millions of retail traders used algorithms to trade it could create a massive amount of volatility in the market. Without the PDT rule, all it would take is one person sneezing on their server to create a runaway flash sale that drops the market by 60% in a couple of seconds.
Popular Questions About The PDT Rule Answered
Most people don’t know why the PDT rule was ever implemented. Many people look into this rule and how it affects their accounts. Well, here I put together some of the most popular questions I get emailed to me.
Will the PDT Rule Ever Be Repealed?
The PDT rule was created in 2001 to combat market volatility and ‘protect’ the average U.S retail trader.
The only way the PDT rule will be repealed is if these two variables go away. The SEC would have to come up with a way to prevent runaway market volatility while also making sure the average retail investor knows what they are doing.
I do not think this will happen in our lifetimes. This is because the average retail investor does not know what they are doing or how much the stock market is stacked against them. If we removed the PDT rule today then within a couple of years the market would crash. Chances are most investors would not be happy with their 401k’s disappearing.
That being said there is a push right now to have the PDT rule removed. Several people have emailed and sent letters to the SEC.
How Long Do You Have to Hold a Stock to Avoid the PDT Rule
The PDT rule will only affect you if you buy and sell a stock within one business day. This is called a ’round-trip’ trade and you can only do 3 of these in a 5-day rolling period.
The easiest way to avoid the PDT rule is to simply sell the stock the day after you buy it. This will ensure that you are not flagged as a PDT rule. There is an entire group of investors out there called swing day traders. They hold a stock overnight and sell it the next day.
What Happens If I Get Flagged As A Pattern Day Trader?
If you get flagged as a pattern day trader you will be issued a margin call for the minimum necessary amount of capital to avoid the PDT ($25,000). If you don’t have the capital your broker will more then likely close the positions in your account or prevent you from trading/investing for 90 days.
Getting flagged as a pattern day trader sucks. As a professional investor, this will happen to you at least once in your career. If you get flagged as a PDT then call your brokerage firm. Most firms will remove the flag one time on an account if you agree to never get flagged again.
How Can I Get Around The PDT Rule
There are 3 ways that you can get around the PDT rule. Generally, this is considered a bad idea as the PDT rule is in place to protect the average retail investor.
First, you can use a cash-only account. This means that you have enough capital to enter into and exit trades without needing to wait for the cash to settle. The trades you buy and sell will still need to settle but with a cash account, you can enter and exit as many trades as you want.
Second, you can deposit at least $25,000 into your brokerage account. This will remove you from the ‘retail investor pool.’ Now you are free to buy and sell as many stocks as you want as fast as you want.
Three, there is a clause in the PDT rule that can allow people under $25,000 to not be flagged as a PDT. Under (F)(8)(B)(ii) of the 2001 SEC document which created the PDT rule if your total round trip trades is less than 6% of the total amount of trades on the account during the same time frame you will not be considered a PDT. This means that if you open 50-60 positions then you can go over the 3 PDT rule.
There you have it; an entire article explaining the 3 reasons why the PDT rule exists in the first place.
It is important to remember that the PDT rule was put in place to protect the average retail investor from themselves. Every retail trader believes that they are better than the next guy but chances are they are not. The SEC put the PDT rule in place to limit market volatility and protect the average U.S retail trader from predatory financial practices.
Here at ChronoHistoria, I am to teach people how to invest and trade properly. Many people make the same mistakes over and over again leading to massive financial losses. Subscribe to the free newsletter and share around the web to help other people grow their investing prowess!
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