PDT & Free Riding

For new and aspiring traders, the various securities ecosystems can seem daunting enough: you have leveraged assets, underlying and derivatives, and an entire industry full of highly skilled, highly trained professionals who exist for the sole purpose of putting your money in their pockets (and perhaps your objective is to eventually join their ranks)… it’s easy for an inexperienced participant to overlook the regulatory concerns accompanying certain trading activities. In this article, I want to briefly highlight two such regulations which are likely to affect FinClub.AI subscribers: Pattern Day Trader (PDT) and Free Riding rules.

Before we begin, I must stress that the purpose of this article is neither to critique these regulations nor to offer “work arounds” to avoid them. There’s no shortage of resources which cover these aspects (and not all solutions are appropriate for all traders) once you know what to search for. My job here is to help you know just that, what to search for. It’s worth noting that failure to understand – and thus inadvertently violate – these rules can have serious financial consequences. Violation of PDT can restrict your ability to trade using the strategy of your choice (if you are a day trader) and possibly lead to onerous day trading margin calls. Worse, violating the free ride rule can lead to your brokerage account being frozen for 90 days, or closed altogether… imagine being in a position you intended to day trade, only to find out you can’t close it for three months.

PDT

According to the SEC and FINRA rules, a “Pattern Day Trader” is one who conducts 4 or more day trades from their margin account within a 5 business day period. Any purchase of a security (including short positions, options, etc.) and following sale of the security on the same business day constitutes a day trade. Note that each transaction counts, not just which days you conduct the trades. For example, if you were to make 2 day trades on a single day that counts as 2 toward your total for PDT purposes, not 1. The period is rolling, meaning that it’s not simply Monday-to- Monday, but any 5 consecutive business days.

What’s more, your brokerage may have more stringent criteria of their own. There are a number of possible reasons for this, including their own risk assessment calculations (in a margin account, they are effectively a lender, after all), not wanting to draw unnecessary regulatory scrutiny (for example, if they set their PDT threshold at 3 instead of 4 day trades per period, they can “flag” your account early and send a warning, which is intended to prevent you from incurring additional stipulations to trade), and so on. They may also flag you as a PDT if they have “reasonable belief” that you are in fact a pattern day trader. Generally, day traders are coveted by brokerages because of the larger commission sums they generate, so you will want to investigate their criteria for PDT in excess of the regulatory statues (if any).

So, what can happen if you’re identified as a PDT? First, you’ll be required to maintain a minimum equity (cash & qualifying securities) balance of $25,000.00, and that amount must be in your account prior to any day trading. To be clear, having a balance below this amount doesn’t prevent you from trading non- day trades. Next, despite whatever margin multiplier you may have previously arranged with your broker, PDT rules state that a pattern day trader may trade up to 4x the maintenance margin excess as of the close of the previous day. Refer to your broker for your specific margin (borrowing) rate and associated fees to calculate what this amount is for you, and keep in mind that holding volatile securities as a portion of your equity balance may have negative unintended consequences. You can find out more about PDT directly from the SEC.

Free Riding

Free Riding is the buying and selling of a security before the investor pays for it, and contrary to the famous words of Eddie Winter (what, no one listens to classic rock anymore? “Come on and take a… never mind), this is something you definitely do not want to do!

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*Photo credit: https://www.imz-ural.com/blog/waffles-the-sidecar- dog

You may be wondering how this is even possible. After all, you received a trade confirmation, your account is showing possession of the security, and you’re exposed to the price change of the asset at that point. However, there are additional steps beyond execution (the trade confirmation, or legal agreement to exchange assets) that must take place prior to selling the given security without violating the Free Ride rule: clearing and settlement.

Briefly, there are two types of clearing, bilateral and central. You can think of bilateral clearing in the same way you might purchase a house, where a stack of paperwork is completed by all parties and the deal is done. Similarly, if an investor were to buy or sell a major holding, they might conduct bilateral clearing to complete the legal settlement steps themselves. For most traders, central clearing – the same legal settlement steps, except performed by a 3 rd party – is far more common. After clearing, there is settlement, which is the actual exchange of money and securities. Only upon completion of settlement is the security considered “paid for.”

…and these things take time. For stock trades, the settlement period is “T+2” (T= the date of the transaction, plus 2 business days). This was formerly T+3, so while this may seem slow by 2019 standards, at least it’s a move in the right direction. Options & bonds settle on the following business day.

The SEC has provided a few good examples which demonstrate what does and does not constitute Free Riding here. Take note that these examples are specific to cash accounts, and that it’s possible to use margin accounts to cover trades for free riding purposes (i.e., not buying positions to the fullest extent your margin allows, but instead using that margin as a “place holder” until settlement occurs). Avoiding free riding is one of those things that, once you’re aware of it, is very easy to understand, yet difficult to practice if you do not develop a system that works for your trading style & strategy; however, as previously noted, free ride violations can result in your account being frozen for 90 days… and a lot of things can happen in 90 days.

While you can imagine that PDT and Free Riding violations are not exactly the kind of legal issues that get you hauled off to jail in cuffs (which has never happened to the best of my knowledge), clearly the penalties for each can have potentially devastating repercussions. As always, I urge you to conduct additional research until you as an individual trader are comfortable with your level of knowledge.

- Mark Gorzycki

CEO & Co-Founder, Finclub.AI