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I built an algo that buys and sells securities in a few minutes. The idea would be to let it do that hundreds of times a day.

After some paper trading tests, I wanted to test it with a couple real orders. I was hit by a few annoying discoveries:

  • As my broker IBKR explains here, a cash account won't let me re-use the proceeds from a trade before it has settled at the clearinghouse, which usually takes 3 business days. I need a margin account to do that
  • So I converted to a margin account, thinking that I won't use the leverage capacity offered by margin -- that I would just make use of the ability to re-use trade proceeds immediately
  • I was quickly hit after a few trades by a message telling me that my next trade would make me a Pattern Day Trader, and that by FINRA rules I have to have $25,000 to be one

My confusion over this can be split into a few sub-questions:

  1. Is my understanding correct that re-using proceeds before settlement doesn't constitute the same type of loan, risk and capability as leverage?
  2. Is there really some risk in re-using immediately a trade's proceeds? Am I naive to believe that if I buy security X from person A, who traded through broker B and sold it to me over exchange C... and person A defaults, surely B and C will guarantee that my broker receives security X (and will chase person A)?
  3. If there is any risk in reinvesting immediately my proceeds, does that mean that re-using the proceeds several times over would be very risky, because the risk compounds?
  4. If re-using day trades proceeds in new day trades is incredibly risky and leads to compounding risk, how does having $25,000 changes anything? If there is no practical risk, isn't this requirement unfair to small investors vs big ones?
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2 Answers 2

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In the US, options settle in one business day and equities settle in two. This isn't a problem if you have a margin account since the broker effectively lends you the money but without a borrow fee.

The PDT rule was implemented after the internet bubble during which many people lost a lot of money day trading. Its purpose is to disincentivize people from day trading, particularly those with small accounts which can be wiped out easily. You could also make the argument that they're protecting the brokers from loss as well.

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  • Does that mean that the broker lends you an arbitrarily large amount of money, without any borrowing fee, if only you have $25,000 to show? Thanks for the background about the PDT rule (I find this quite unfair though, and against the idea of a free market)
    – Mysterry
    Jan 4, 2022 at 0:25
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    Some brokers raised PDT margin requirements a bit last fall (say 25% to 30%). I don't know where they stand now. For the past 20 years prior to that, a PDT trader could utilize 4:1 margin intraday but had to be back to 2:1 margin overnight. Borrow rates are only charged for overnight holdings. As for a free market, that only exists in theory in the minds of some. Regulations are implemented to ensure the function and safety of the markets. The margin requirement and the margin maintenance requirement are a perfect example.
    – Bob Baerker
    Jan 4, 2022 at 1:23
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Counterparty risk

Regarding your second sub-question (IMHO they're different enough to put them as separate questions), counterparty risk is a thing.

For exchange traded securities you should be generally protected from that, but for OTC trades the insolvency of some party in the settlement (not necessarily the buyer/seller, it could be also some bank in the middle like in the Lehmans insolvency) can leave you hanging.

There is also the risk of your own broker becoming insolvent. While they should protect your assets by keeping them in a separate entity, it may be the case that they (illegaly/fraudulently) have not done so, in which case it may turn out that for one leg of many transactions you owe stuff to others, but for the other leg of these transactions your broker owes you money you will never receive.

Counterparty risk materializing is relatively rare, but when it does have an impact, that impact can be sudden and large.

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