Anyone who has actively traded securities in a brokerage account knows that skill, timing, and discipline are just three of the many attributes necessary for success. You also need a comprehensive understanding of the rules that govern brokerage accounts if you want to avoid running into problems with your brokerage firm.
Before placing your first trade, you will need to decide whether you plan to trade on a cash basis or on margin. In this lesson, we will review the trading rules and violations that pertain to cash account trading.
As the term implies, a cash account requires that 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 three business days (T+3). That means that if you buy a stock on a Monday, settlement date would be Thursday.
If you plan to trade strictly on a cash basis, there are three types of potential violations you should aim to avoid: cash liquidations, good faith violations, and free riding.
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 Thursday.
A cash liquidation violation will occur. Why? Because when the ABC purchase settles on Thursday, 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 Friday.
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.
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 1 – 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 Thursday (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 2 – 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.
- Near market close on Monday, Trudy buys $10,500 of ABC stock.
- On Wednesday 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.
Free riding violation
What is it? While the term “free riding” may sound like a pleasant experience, it’s anything but. A free riding 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 two hypothetical traders (Marty and Trudy) might incur free riding violations.
Free riding example 1 – 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 Thursday’s settlement date.
- On Friday, Marty sells ABC stock for $10,500 to cover the cost of his purchase.
A free riding violation has occurred because Marty did not pay for the stock in full prior to selling it.
Free riding example 2 – 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 Thursday through an electronic funds transfer.
- On Tuesday, ABC stock rises dramatically in value due to rumors of a takeover.
- On Wednesday morning, Trudy sells ABC stock for $15,000 and decides it is no longer necessary to send the $5,000 payment.
A free riding violation has occurred 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 free riding 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. Click here to see where to locate account specific details on Fidelity.com to help monitor a cash account.