Settlement Date Vs. Purchase Date
When you buy stocks through an online brokerage account, it appears that you place an order and a few seconds later you own the stocks. However, that is not entirely true. The settlement process for the stock market means that you will not officially own the stocks until three days after you made the purchase.
Settlement of Stock Trades
When shares of stock are purchased or sold, the two sides of the transaction must fulfill their obligations. The buyer must pay for the shares, and the seller must deliver the shares. In the days before online and computerized trading, this meant delivering a check and share certificates. A standardized period of time -- called settlement -- was allowed to complete the transaction. Until 1995, investors had five days to settle a stock trade. The current settlement period is three business days after the trade date, often referred to as T+3 settlement.
Purchase Price on Trade Date
Even though a stock purchase does not settle until three days later, the share price of the purchase on the trade date is the effective price. The three days to pay does not give you the right to back out of the stock purchase if the price suddenly drops before the settlement date. If an investor does not pay for a stock purchase by the settlement date, the broker can sell the shares and charge the investor for any losses plus costs and fees incurred to unload the shares.
The T+3 settlement process is most visible with dividend record and payment dates. To receive a dividend, investors must own shares on the declared record date. With the three-day settlement, shares must be purchased at least three days earlier for an investor to be the owner of record on the record date. This is why a stock goes ex-dividend two business days before the record date. Stock purchases on the ex-dividend date will not settle and become official until after the record date.
Rapid Buying and Selling
The T+3 settlement on stock trades means investors need to be careful with the rapid buying and selling of stocks. It is OK to buy shares one day and sell the next -- the settlements will just be three days in the future for each end of the trade. Rules start to be broken if you buy and sell stock with unsettled money. For example, you sell a stock, buy another the same day with the proceeds from the sale and sell the second stock a day later. You bought and sold with money you did not officially have. This is called "freeriding" and may result in a trading freeze on your account. If you plan to trade actively, a margin account with the ability to borrow to buy stocks will minimize this problem.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.