The End of PDT: What Equity Markets Learned from Futures

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The Pattern Day Trader rule was originally introduced in 2001 to protect retail traders, apparently, from excessive day trading risks.

Traders were required to have $25,000 in their account to be able to day trade. If you fell below that, you were limited to only a few trades per week, buying and selling, approximately 3 day trades in a 5-day period per FINRA Rule 4210.

Apparently this was risk control, but it's more of a restriction and handcuffs than protection. Many traders in equities, including myself back in the day, gravitated towards futures instead because the ridiculous PDT rule didn't exist. You were able to participate with smaller account sizes given that you were able to meet the margin requirements required for those futures contracts.

The CME Group has operated for many years without limiting traders and restricting the amount of trades they can place. Futures markets required margin to be posted for each specific contract and risk controls to be imposed by the FCM. This framework was built to limit catastrophic risk without banning trading activity.

As a result, the futures markets prospered from this shift from equities to futures, giving them new participants in the derivatives marketplace.

The contrast between futures and equities markets was clear. The PDT rule was highly criticized by equities traders due to the fact that it felt very restrictive, and on top of that the leverage provided was nothing close to what the futures markets provided. With a margin account in an equities brokerage, you might have 2x the leverage, so if you had a $25,000 account, you could trade $50,000 worth of equities.

With futures markets, there are different margin requirements. There is initial margin, which is a percentage of the notional value of the contract. There is intraday margin, which is set by the FCM. This can be multiples lower than the initial margin. Also, there is maintenance margin, which is margin you have to post to hold the position overnight or over the weekend. To know these margins, go check your specific futures broker on their margin rates.

On another note, borrowing on margin when trading in equities results in margin borrow fees, which are a few percentage points charged against the margin loan. This kind of fee doesn't exist in futures markets. Futures have exchange clearing fees, NFA fees, and the broker’s own commission rates.

With that being said, equities have shifted to a more zero-commission model with fractional shares and whatnot. In the equity space, there are thousands of stocks to trade, all with varying types of liquidity and various prices from micro caps to large caps to mega caps.

In futures markets, the futures contracts are sized accordingly, whether it be commodities, livestock, precious metals, energy, equity index, bonds, and rates. There is a notional value per contract, and the contracts usually represent indexes, not individual stocks, so it's more of a global macro view versus a micro view focusing on specific equity names.

Maybe one day the futures markets might undertake a zero-commission or zero-fee model, but even then, the fees are still small relative to the leverage you possess.

In my case, equities trading for me became more of a pick-stocks-for-the-long-run, buy-and-hold, buy once a month or buy every week kind of deal. I didn't even bother day trading. I thought it was pointless just because it costs too much for less returns versus trading futures markets.

The PDT rule for me was just annoying because it measured trade frequency versus actual risk. For example, equities can only go to zero, so if you had a $25,000 account and you put it all into a stock and it announced bankruptcy and goes to zero, that's your max loss. You shouldn't be restricted on how many times you trade it.

Structurally, it's outdated, and thank goodness it's gone.

Risk, in my opinion, was higher when the PDT rule was active because it forced traders to hold positions overnight they wouldn't hold otherwise. Now, if it was a cash account, there's really no leverage, then buy and hold, right? The futures margin requirements were more clean-cut.

Futures are traded differently in the eyes of taxation. They are marked to market (M2M) daily. All debts are paid, and all positions are collateralized against something, whether it be cash margin collateral, treasury bonds, marketable securities, etc.

It was simple: you get liquidated if you couldn't post the margin, especially overnight. Therefore, intraday traders for futures markets know that they have to flatten their positions 15 minutes before markets close, the overnight rollover into the Globex session the next day.

When it's less than 15 minutes before market close, the margin requirements change into maintenance margin. That means instead of $500 intraday to maintain an E-mini S&P 500 position, the maintenance is approximately around $26,600 (53x more than intraday margins) to hold the position overnight into the next session.

Then intraday margins will kick back into $500 or whatever intraday is for your broker when Globex opens at 18:00 hours Eastern Standard Time.

This increase basically states: if you want to hold, you better have $26,000 or $27,000 in the account just in case a nightmare scenario happens during the overnight rollover so you can absorb some drawdown.

Furthermore, this becomes riskier if you try to hold over the weekend. You better have deep pockets. So intraday traders in futures see this as a massive warning, and they know they have to close at the market close or sooner or else face a margin call and other issues with the FCM.

So in short, there are a lot of checks and balances that make the margin system in futures work.

I have a strong feeling that in about 12 to 18 months, when equities brokers eventually transition into a more margin-based system, they would have taken notes or consulted with CME Group on how to implement new margin-based requirements.

In the end, it's a win-win for all markets, equities and futures. Futures have proven that their system works and that the PDT rule was bound to be axed.

Futures regulation focused on capital requirements and meeting those requirements, while PDT only cared about limits of trading frequency.

From my personal experience, taxation when trading futures is 100 times more efficient than equities taxation.

Just a reminder, nothing I say here is financial or accounting advice. I'm not a licensed advisor or accountant. Anything I say here is from personal experience, and it's just for educational purposes only. As I stated earlier, look at all the disclaimers, they all lead to one page.

Now with that being said, I remember my accountant stated:

“Traders without a 475(f) election must report trades on Form 8949 and Schedule D.”

This alone added multiple layers of complexity when filing taxes. This is on top of reconciling 1099-B reporting and wash sales. These don't exist in futures, by the way. Wash sales are just another equities restriction in my opinion.

Anyways, futures, on the other hand, are classified under Section 1256, reported on Form 6781. Furthermore, they are tax-advantageous. They are taxed 60/40, meaning 60% long-term capital gains and 40% short-term regardless of the holding period.

So it's a blended rate of taxation end of year. Futures traders tend to save on taxes versus equities traders, and the filing is cheaper.

So now that you know that, don’t you see why futures became a haven for intraday speculators? It had less restrictions, but the restrictions and rules were fair, and it generated an environment in which all participants played by the rules.

For the most part, there were some that broke rules, but they were either banned or faced penalties, but that’s another discussion in and of itself that I’ll probably talk about in the future.

In closing, futures have proven that active trading could function without PDT with proper margin requirements.

Now the question is: would the equities markets adopt similar frameworks in terms of margin, or would they go into another downward spiral and create new restrictions, a new iteration of PDT for this decade?

The way I see it is if the SEC is smart, they would adopt a similar margin method and mark-to-market accounting for equities.

The adoption of a margin-based framework would likely increase retail participation, especially in equities markets, because the barriers to entry have become lower and they’re going to be competitive with the futures markets.

Who knows, if there is an equities broker that is compelling, maybe I would day trade with them again, but only if the taxation is like futures. If not, I'm good, I'll stick to trading futures.

We will see who were the early adopters that can present a working model, because apparently there's a phase-in period of about 6 to 18 months.

Anyways, that's just my long-winded opinion on the matter. We'll see if the equities space builds a working model.

So till then, trade well.

Lastly

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~Asymmetric_Vol