If you have even a beginner level understanding of day trading then you’ve probably heard of Pattern Day Trading and with limited knowledge you might have thought, ‘Why is Pattern Day Trading illegal?’.
Questions like why pattern day trading is seen as risky or even illegal crop up frequently. But the truth is, it’s not that simple. Pattern day trading is neither inherently bad nor illegal, but rather a practice governed by a set of regulations designed to protect investors in the volatile landscape of day trading financial markets.
And as a day trader learning the fundamental knowledge of day trading concepts and market movements while staying compliant with financial regulations is key.
Day trading is a popular type of trading that is characterized by its rapid buy-and-sell transactions within a single trading day. And a characteristic of good day traders is that they can find stocks that are highly volatile and capitalize on short-term market fluctuations to be profitable through day trading.
Yet, the very volatility that attracts traders to this style of trading also exposes them to significant risk, and this risk is even amplified further by the potential leverage provided by margin accounts (we explain a lot more on the concept of leverage in this post as it is crucial to understanding the Pattern Day Trading rule).
In response to these risks, the United States government implemented the Pattern Day Trading (PDT) rule as a regulatory measure aimed at safeguarding investors.
To answer the question ‘Why is Pattern Day Trading illegal?’ you need to wrap your head around what it is and how it fits into the regulatory landscape set by the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC).
And that’s exactly what we will cover in this post.
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Table of Contents
What is the Pattern Day Trading Rule Or PDT Rule?
Pattern Day Trading (PDT) as a regulation set by the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) refers to a specific trading activity governed by rules designed to protect investors and maintain market stability.
According to FINRA rules, a pattern day trader is defined as any margin account trader who executes four or more day trades within a rolling five-business-day period, provided that the number of day trades is more than 6% of the total trading activity for that same five-day period.
So, basically, if you trade a lot using a margin account, there are some chances that your account gets flagged as Pattern Day Trading. And this is the reason why many traders have asked the question, Why is Pattern Day Trading illegal?’ which is really not the right question to ask in the first place.
Instead a day trader should be trying to understand how to stay compliant and not violate the Pattern Day Trading rule.
The PDT was initially approved in 2001 in order to protect investors from losing all their money. The concept behind it is pretty simple, FINRA wanted to protect new investors starting day trading and make them choose a hold strategy over risking substantial losses through placing too many trades in a short period of time.A ‘hold strategy’ consists of buying and holding a share of stock for months or years. Which tends to be less risky than day trading, and that’s exactly what FINRA wanted.
What Happens When You are Classified as a Pattern Day Trader?
Violating pattern day trading regulations can have serious consequences, including penalties imposed by regulatory bodies. Common repercussions for non-compliance may include trading restrictions, fines, or even suspension or expulsion from the securities industry. Additionally, repeated violations can tarnish a trader’s reputation and make it difficult to engage in future trading activities.
Once an investor is classified as a pattern day trader, they must maintain a minimum account equity of $25,000 in order to continue day trading. This equity must be maintained at all times and cannot be withdrawn or transferred while the account is classified as a pattern day trading account.
The SEC and FINRA established these regulations to address the increased risks associated with day trading, including the potential for rapid and substantial losses. By requiring pattern day traders to maintain a higher account equity, regulators aim to ensure that traders have sufficient funds to cover potential losses and reduce the likelihood of default.
Failure to comply with PDT regulations can result in restrictions on trading activity, such as the imposition of a 90-day trading restriction on the account. Repeat violations may lead to more severe penalties, including account suspension or closure.
Pattern Day Trading regulations imposed by FINRA and the SEC serve to protect investors while allowing them to participate in the potentially lucrative but risky world of day trading. Understanding and adhering to these regulations is essential for you to operate and trade within the boundaries of the law and minimize the risks associated with trading activities.
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The PDT and Margin Accounts
As I mentioned before, the pattern day trading rule is only applicable for margin accounts.
A margin account allows investors to borrow funds from their brokerage firm to purchase securities, leveraging their buying power. Since margin trading involves borrowing money, it inherently carries additional risks.
So, as an example, if you have a leverage of 5:1 and $1k in your account, this means that you can trade with $5k instead of $1k.
The PDT rule was implemented by regulatory bodies like FINRA and the SEC to address the increased risks associated with frequent trading in margin accounts.
It seems that FINRA thinks that trading with leverage is too risky. And it may be, with margins accounts you can win more money, but you can lose it a lot faster. The risk that this implies is the main reason why they need you to have at less $25.000 in your account. If you reduce this amount, the brokers will restrict you to only doing 4 trades in five days
What happens if your account gets flagged in the middle of a trade? Well, if you’re in a position after the four trades, you will need to wait for the five-day period to end in order to close that position.
This regulation requires that any trader classified as a pattern day trader, as defined by executing four or more day trades within a rolling five-business-day period, must maintain a minimum account equity of $25,000. This equity must be in the account before day trading activities can commence and must be maintained at all times.
The PDT rule does not apply to cash accounts, where trades are made using only the cash available in the account without any borrowing.
But, it’s important to note that while cash accounts are not subject to the PDT rule, they still have their own set of regulations and restrictions.
Also an important considerations is that The PDT applies only to trading accounts with margins that are under the regulation of FINRA in the US. The organization can’t regulate brokers outside the US.
Is Pattern Day Trading Illegal?
So now you should understand that really it’s not illegal to pattern day trade or even to have your account flagged as a Pattern Day Trader so the question of, is pattern day trading illegal?’ really is not the right quesiton to ask.
Instead a trader should be asking, how can I trade in a manner that my account does not get flagged as a PDT account in the first place?
While pattern day trading may seem complex and risky, it’s important to clarify that engaging in this trading strategy is not inherently illegal. Instead, pattern day trading is regulated by entities like FINRA and the SEC to ensure investor protection and market stability. Misunderstandings surrounding its legality can stem from misconceptions about the risks involved or confusion about regulatory requirements.
Pattern day trading operates within a legal framework established by regulatory authorities. Rules set forth by FINRA and the SEC outline requirements for pattern day traders, including minimum equity thresholds and restrictions on trading activity as we have defined above in this post.
By adhering to these regulations, traders can operate within the bounds of the law and mitigate the risk of legal repercussions. And simplifying your day trading including technical analysis and indicators is an ideal approach to take in order to become a consistent trader and build complexity as you learn and grow in your trading skill and knowledge.
So now you understand how it works, and you know the PDT rule is not illegal. And really the easiest way to avoid the pattern day trading rule is not to use a margin account. If you trade using a cash account, you would not have any issue with violating the PDT rule.
And most importantly now you understand that the Pattern Day Trading rule is not an actual trading strategy and you confuse the PDT with price patterns or chart patterns.
Recommended Read: The Best Price Action Patterns In Day Trading
Conclusion
By understanding the legal framework surrounding Pattern Day Trading and adhering to regulatory requirements, traders can navigate the complexities of the market while minimizing the risk of legal entanglements.
So for newer traders you should understand that the PDT is not illegal but there are consequences to violating this regulation set by FINRA and the SEC which especially targets high frequency traders who use leverage.
