Pattern Day Trading and How to Avoid It with a Cash Account

What is Pattern Day Trading?

Pattern Day Trading is a regulatory designation for traders who execute four or more day trades within five business days in a margin account, provided that the number of day trades represents more than six percent of the total trades in the account during that period. A day trade is defined as the purchase and sale of the same security (or securities) within a single trading day.

The Financial Industry Regulatory Authority (FINRA) enforces rules around Pattern Day Trading to ensure that individuals engaged in frequent trading have sufficient capital to cover potential losses. Pattern Day Traders are required to maintain a minimum equity of $25,000 in their margin accounts on any day that they trade. If the account falls below this threshold, the trader is prohibited from day trading until the account is restored to the minimum equity level.

Risks Associated with Pattern Day Trading

1. High Capital Requirement: Maintaining the $25,000 minimum equity can be challenging for small retail traders.
2. Margin Risks: Trading on margin can amplify both gains and losses, increasing the risk of significant financial losses.
3. Regulatory Restrictions: Failure to meet the equity requirements can lead to account restrictions, limiting trading capabilities.

Avoiding Pattern Day Trading by Using a Cash Account

One effective way to avoid the Pattern Day Trading designation and its associated requirements is by trading in a cash account instead of a margin account.

Key Differences Between Cash Accounts and Margin Accounts:

• Cash Account: You can only trade with the actual funds you have available. This eliminates the risk of borrowing money to trade, which is inherent in margin accounts.
• Margin Account: Allows you to borrow funds from your broker to trade, thereby increasing your buying power but also exposing you to higher risk and regulatory requirements.

Benefits of Using a Cash Account:

1. No Pattern Day Trading Restrictions: Cash accounts are not subject to Pattern Day Trading rules, so you can trade without worrying about meeting the $25,000 equity requirement.
2. Lower Risk: Since you are only trading with the money you have, there is no risk of margin calls or amplified losses due to borrowed funds.
3. Simplified Trading: Trading with a cash account simplifies your trading operations, as you don’t need to monitor margin requirements or interest on borrowed funds.

Limitations:

• Settlement Periods: Cash accounts are subject to settlement periods, usually two business days (T+2) for stocks. You need to wait for the settlement before you can use the proceeds from a sale to make another trade. This can limit the frequency of your trades compared to a margin account.
• No Leverage: You can’t use leverage to increase your buying power, which might limit potential profits if you were hoping to use borrowed funds to trade more significant positions.

Conclusion

By choosing to operate with a cash account, traders can effectively avoid the constraints and risks associated with Pattern Day Trading regulations. While this approach limits the ability to leverage trades and necessitates managing cash flow in line with settlement periods, it provides a safer and more straightforward trading environment, especially for those with limited capital or a preference for avoiding debt and margin requirements.