The ‘Pattern Day Trader’ (PDT) is a FINRA (Financial Industry Regulatory Authority) classification for a stock market trader who executes four or more day trades in five business days in a margin account. Provided the number of day trades is more than six percent of the customer’s total trading activity for that same five-day period. In this article, I am going to discuss if the PDT is legal and why statement about it being here to protect investors is a giant lie.
No, pattern day trading is not illegal! The US government portrays it as being extremely risky, and thus, they created the PDT rule to protect the capital of investors. They don’t forbid margin accounts or trading with accounts that have less than $25,000 of capital, but they try to regulate them as much as possible. Let’s have a closer look at why a successful day trader needs to avoid the PDT rule at all costs.
Why does the PDT rule exist?
To better understand why pattern day trading is not illegal, we need to take a look at how and why the PDT rule was created.
The FINRA initially approved the PDT rule in 2001 to protect investors from losing money. Their general conception was to hinder newer traders from starting day trading and encouraging them to use a buy and hold strategy. Buying and holding a stock for months and years is essentially what an investor does. Investors don’t buy a stock based on patterns on a chart, and they analyze the fundamentals of a company to make an informed investment decision. This strategy seems less risky than trading based on patterns, at least in the eyes of the FINRA.
Unwanted margin accounts
Margin accounts enable you to get leverage in buying power. Leverage is simply an increase in buying power, which means that you can buy more stock than what your account size would allow. Let’s say you have a 6:1 leverage and $1,000 in your account. That would mean you can buy stock worth $6,000.
To give you an idea of how far leverage could go: Tradenet’s smallest package gives you a 35:1 leverage with a $399 investment. So that means you can buy stock worth $14,000 with very little money.
To make it even more clear how leverage works, I made an illustration down below.
The PDT rule only applies to margin accounts since the FINRA sees trading with leverage as risky as you could basically lose your account faster. This higher risk is the reason why they require you to have at least $25,000 in your account. Once you fall under it, brokers will restrict you to 4 trades in five days. If you are still in a position after four trades, you have to wait until the five day period is over till you can get rid of your position.
However, if you would trade on a cash account that has no leverage, you would not be subjected to the PDT rule.
Only for accounts in the US
The PDT rule only applies to accounts regulated by FINRA inside the US. The FINRA can not regulate brokers outside the US, that’s why you see a lot of brokers that are located offshore in the Bahamas, for example.
The lie of investing being safer than pattern trading
This is something that is boggling me the most, and I wished someone would have told me this earlier. The FINRA strongly believes that buying and holding a stock is safer than trading patterns and having a defined risk analysis. But how would you know what stock to buy? Do you go after some random analysts that recommend a stock? Or because you like the product the company produces? Or do you make an in-depth fundamental analysis of the company’s financials with the imaginary financials degree you have?
You should never buy a stock because you love a company or listen to anyone that recommends it to you. If you want to become an investor, you need to put in a ton of time to understand a company from top to bottom.
A much more comfortable and safer way to make money is to trade patterns. You have much more control over your trades with a defined risk and reward setup that will prevent you from losing all of your hard-earned cash.
Why the FINRA wants to punish the safer way to trade is beyond me. But if you still believe investing is the way to go, you may be better off buying some lottery tickets with that money.
If you want to learn how to trade profitably, consider checking out our free trading guide here.
The PDT rule is counterproductive
Since the PDT requires to invest at least $25,000 into an account, it will rule out all the people that don’t have the capital to learn day trading properly. Thus the rule is seen as very anti-competitive.
Most traders consider the PDT rule as “governmental paternalism,” and that it is hurting people that want to learn day trading without putting a ton of money on the table. But how could this rule hinder people from having success?
Like with everything in life, you will not be able to learn something if you don’t dive deeply into it. The same applies to trading and especially to trading with more money on the table. The more money you risk, the more of your emotions will interfere with your trading decisions. Let me clarify this from my own experience and what I learned from it.
Leverage gave me discipline
My first account was a $50,000 account without any leverage. So I bought stocks as a newbie and started to average down once the trade went against me until I lost almost all of the $50k. I had no stop-loss in mind, I just wanted to make my money back and there I had it, a total disaster. So when did I start to rethink my trading style? That’s simple – when I finally sold my shares for a $45k loss.
But what if I had a similar account with Tradenet for example? With $2,700, I would get an account with $80,000 of buying power. And here is the important thing: Even though I can trade with $80k, I can ultimately only lose $4,000 until my account gets closed down. So effectively, I would only lose the $2,700. Even if I open up another account with Tradenet and lose it again, I would be far away from the $45k I lost with my regular account.
Leverage will teach you the discipline to trade much more carefully as the max-loss will always be in the back of your head.
A lot of the profitable traders have blown through an account to learn their lesson, and it helped them to build up more discipline, so their next account does not end in a disaster.
The PDT rule does not allow you to learn
The best way to learn is by making mistakes and improve along the way. You could trade in a simulator all day long, but it would never be the same as trading with real money. You will inevitably make mistakes as your emotions can get in your way, but that’s all part of a learning process every trader has to go through.
The PDT rule can make you lose more money
As I mentioned further up, you can get stuck in a position for several days without being able to get rid of it. Imagine you planned a trade and you bought shares at a specific price. Now the price reaches your stop-loss, but you are not able to sell because you already reached your maximum number of trades. Your only option will be to lose more and more of your money as the trade goes against you until the 5-day period is over. Not that great right?
Conclusion
Being a pattern day trader is certainly not illegal. But no matter how you turn it, what the US government did with the pattern day trader rule is very anti-competitive and does not give everyone the same opportunity. Even if they say they do it in the best interest of beginner traders, it is quite the opposite they are achieving.
Trading with high leverage is a great way to learn how to trade with a lot of money and stay disciplined with every trade you take. To do that, you have no chance but to get a broker outside of the US. If you are searching for a good broker without the PDT rule, consider checking out one of these picks here.