If you ever received a message from your broker informing you that you've committed a trading violation, the chances are good that it’s because you sold a security too soon. The U.S. Securities and Exchange Commission calls this violation “free-riding,” and the fallout can be quite inconvenient. If you understand how you trigger a free-riding violation, you’re much less likely to repeat the mistake.
When you buy or sell a stock in the U.S., you start a chain reaction that takes three days to complete. The SEC calls this “trade date plus three days settlement.” Though you own stock as soon as you buy it, the shares don’t transfer to your account until three business days later. During that time, many people (or, more likely, computer algorithms) are verifying your trade, making sure the account numbers of the buyer and seller are correct and accounting for other details such as dividend payments. At the end of the three days, the money leaves your brokerage account, replaced by the shares you bought.
Cash vs. Margin
Many traders have margin brokerage accounts, which are essentially a loan from your broker to help pay for the securities you buy. Normally, you can finance up to 50 percent of your purchases with margin. For example, if you have $10,000 in cash in your margin account, you can buy $20,000 worth of stock. The shares you buy are collateral for the loan of $10,000. If the stock price goes down, you’ll owe more collateral, which usually means you’ll get a margin call from your broker demanding more cash. If you don’t replenish the account immediately, the broker will sell your shares to cover its loan. This locks in your loss. Traders who don’t want to use margin keep a cash-only account. Cash-only accounts need to have the entire trade cost available on the day of settlement, while margin accounts only need enough funds to maintain the margin.
The Federal Reserve Board’s Regulation T outlaws free-riding, which is selling a security before you pay for it. For example, suppose you have $20,000 in your cash account. You buy $15,000 of ABC stock on Monday. On Tuesday, you sell the ABC stock for $16,000 and buy shares of stock XYZ worth $14,000. That’s fine because you’ll be receiving on trade date plus three, or Friday, the $16,000 from the Tuesday sale of ABC stock. The proceeds are enough to pay on Friday for the Tuesday purchase of XYZ. However, you're free-riding if you sell the XYZ shares on Wednesday because you haven’t paid for them yet. Had you waited three days to sell the shares – that is, on Friday, when the settled ABC proceeds post to your account – you’d have avoided the violation.
The penalty for free-riding is that your broker will freeze your account for 90 days. This doesn't mean you can’t trade during the penalty period. It does mean you must have the cash upfront to buy securities. You can’t rely on unsettled cash to pay for securities. In other words, you have to pay for your purchases on the trade date, not the settlement date. Armed with this knowledge, you can avoid premature sale of a security and escape the inconvenience of a frozen account.
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