Using Leveraged ETF’s To Avoid PDT Rule

The pattern day trader or PDT rule that was implemented by the SEC on February 27, 2001 requires that all “day trader” accounts have least a balance of at least $25,000 in a margin account. This is referred to as FINRA Rule 2520.

A day trader is considered someone who buys and sells the same security in the same day, and does this 4 or more times in any 5 consecutive trading day period.

With the increased popularity and liquidity of leveraged ETF’s, many traders can now day trade ETF’s as a replacement for day trading stocks (yes, your selection is limited, but how many day traders trade only e-mini futures?).

Why Do Traders Use Margin?

Traders need a margin account to either sell short a stock or get more leverage. For example, if I wanted to take a short-term day trade position on a 1% move, where I would exit for profit after the underlying stock moved 1% (in my direction or against me), the most I could risk if I used my entire account balance to trade is just 1%. I.e. Buy $10,000 worth of stock, move up or down 1%, sell it for profit or loss.

But for my portfolio, I want to take a 2% risk per trade, but I am targeting a short-term 1% move in the underlying stock. So I need at least 2x margin (i.e. 2x leverage) to obtain my desired position sizing.

I have other short-term plays where I’m looking at small moves in the underlying such as only a 0.5% move. I also want the flexibility to execute multiple concurrent trades. If I have to use my entire account balance to execute a trade, I’m limited in my trading opportunities.

Pow!

If you don’t use a margin account, you are not subject to PDT limits!

So how do you get the leverage you need (for position sizing and trading multiple open positions concurrently), yet have the flexibility to day trade, i.e. buy and sell as often as you want in a single trading day?

You Don’t Need Margin to trade ETF’s

There are many liquid 2x and 3x leveraged ETF’s that give you enough leverage for position sizing and maintaining multiple positions. The popular ETF’s have very tight bid/ask spreads, usually half-a-cent.

Let’s be serious, if you have under $25,000 in your trading account, you probably are not looking to open more than a few positions at a time, anyways. You just want the flexibility to trade while you build up your account.

Bam!

Inverse ETF’s let you trade short without needing margin!

Not only are there inverse ETF’s, but they are also 2x and 3x leveraged, inverse ETF’s. The small day trader has a lot more options now to actually day trade with real position sizing thanks to the revolution in ETF’s.

Trade ETF’s In Your 401K and IRA

If you have an employer 401k or IRA account that you cannot convert to a margin IRA account until you leave your current job, and you want to trade it, most workplace retirement brokers allow you use up to 50% of your account for discretionary trading (i.e. you can trade any issue and not limit yourself to just the broker’s mutual funds).

Sometimes the commissions per trade are a bit steeper compared to what most discount and direct access brokers charge (e.g. 1-cent or half-cent per share), the use of ETF’s to increase your position size results in a smaller percentage impact on fees. For example, I pay $20 round trip with my employer T. Rowe Price retirement account. If my average trade size is, say $200 profit or loss, that $20 commission is way too steep at 10%. I’ll wait until my average trade size is at least $500 before trading (keep in mind that higher frequency day trading results in a higher commission ratio relative to trade size). As I trade 2000+ shares per trade, the retail cost I pay for my workplace retirement plan ends up being about the same or cheaper than a discount broker or direct access broker.

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