Before placing your first trade, you will need to decide whether you plan to trade on a cash basis or on margin.
A cash account requires you pay for all purchases in full by the settlement date. For example, if you bought 1,000 shares of ABC stock on Monday for $10,000, you would need to have $10,000 in cash available in your account to pay for the trade on settlement date. According to industry standards, most securities have a settlement date that occurs on trade date plus 1 business days (T+1). That means that if you buy a stock on a Monday, settlement date would be Tuesday.
If you plan to trade strictly on a cash basis, there are 3 types of potential violations you should aim to avoid: good faith violations, freeriding, and cash liquidations.
Good faith violation
What is it? A good faith violation occurs when you buy a security and sell it before paying for the initial purchase in full with settled funds. Only cash or the sales proceeds of fully paid for securities qualify as "settled funds."
Liquidating a position before it was ever paid for with settled funds is considered a "good faith violation" because no good faith effort was made to deposit additional cash into the account prior to settlement date. The following examples illustrate how two hypothetical traders (Marty and Trudy) might incur good faith violations:
Good faith violation example, Marty:
- Cash available to trade = $0.00
- On Monday morning, Marty sells XYZ stock and nets $10,000 in cash account proceeds
- On Monday afternoon, he buys ABC stock for $10,000
If Marty sells ABC stock prior to Tuesday (the settlement date of the XYZ sale), the transaction would be deemed a good faith violation because ABC stock was sold before the account had sufficient funds to fully pay for the purchase.
Good faith violation example, Trudy:
- Cash available to trade = $10,000, all of which is settled
- On Monday morning, Trudy buys $10,000 of XYZ stock
- On Monday mid-day, she sells XYZ stock for $10,500
At this point, Trudy has not incurred a good faith violation because she had sufficient settled funds to pay for the purchase of XYZ stock at the time of the purchase. However:
- Near market close on later Monday, Trudy buys $10,500 of ABC stock
- On Monday afternoon, she sells ABC stock and incurs a good faith violation
- This trade is a violation because Trudy sold ABC before Monday's sale of XYZ stock settled and those proceeds became available to pay for the purchase of ABC stock
Consequences: If you incur three good faith violations in a 12-month period in a cash account, your brokerage firm will restrict your account. This means you will only be able to buy securities if you have sufficient settled cash in the account prior to placing a trade. This restriction will be effective for 90 calendar days.
Freeriding violation
What is it? While the term "freeriding" may sound like a pleasant experience, it's not. A freeriding violation occurs when you buy securities and then pay for that purchase by using the proceeds from a sale of the same securities. This practice violates Regulation T of the Federal Reserve Board concerning broker-dealer credit to customers. The following examples illustrate how 2 hypothetical traders (Marty and Trudy) might incur freeriding violations.
Freeriding example, Marty:
- Marty has $0 cash available to trade
- On Monday morning, Marty buys $10,000 of ABC stock
- No payment is received from Marty by Tuesday's settlement date
- On Wednesday, Marty sells ABC stock for $10,500 to cover the cost of his purchase
A freeriding violation occurs because Marty did not pay for the stock in full prior to selling it.
Freeriding example, Trudy:
- Trudy has $5,000 cash available to trade
- On Monday morning, she buys $10,000 of ABC stock with the intention of sending a $5,000 payment before Tuesday through an electronic funds transfer
- Later in the day on Monday, ABC stock rises dramatically in value due to rumors of a takeover
- Later in the day on Tuesday, Trudy sells ABC stock for $15,000 and decides it is no longer necessary to send the $5,000 payment
A freeriding violation has occurs because the $10,000 purchase of ABC stock was paid for, in part, with proceeds from the sale of ABC stock.
Consequences: If you incur one freeriding violation in a 12-month period in a cash account, your brokerage firm will restrict your account. This means you will only be able to buy securities if you have sufficient settled cash in the account prior to placing a trade. This restriction will be effective for 90 calendar days.
As these examples illustrate, it's easy to encounter problems if you are an active trader and don't fully understand cash account trading rules. It is important to maintain sufficient settled funds to pay for purchases in full by settlement date to help you avoid cash account restrictions.
Cash liquidation violation
What is it? A cash liquidation violation occurs when you buy securities and cover the cost of that purchase by selling other fully paid securities after the purchase date. This is considered a violation because brokerage industry rules require you to have sufficient settled cash in your account to cover purchases on settlement date. The following example illustrates how Marty, a hypothetical trader, might incur a cash liquidation violation:
Cash liquidation violation example, Marty:
- Cash available to trade = $0.00
- On Monday, Marty buys $10,000 of ABC stock
- On Tuesday, he sells $12,500 of XYZ stock to raise cash to pay for the ABC trade that will settle on Tuesday
A cash liquidation violation will occur. Why? Because when the ABC purchase settles on Tuesday, Marty's cash account will not have sufficient settled cash to pay for the purchase because the sale of the XYZ stock will not settle until Wednesday.
Consequences: If you incur three cash liquidation violations in a 12-month period in a cash account, your brokerage firm will restrict your account. This means you will only be able to buy securities if you have sufficient settled cash in the account prior to placing a trade. This restriction will be effective for 90 calendar days.