If you sell a stock security too soon after purchasing it, you may commit a trading violation. The U.S. Securities and Exchange Commission (SEC) calls this violation “free-riding.” Formerly, this time frame was three days after purchasing a security, but in 2017, the SEC shortened this period to two days. The reason for waiting two days is to allow the settlement cycle to run its course and ensure the successful transfer of stock securities.
Waiting two days to sell a stock will help you avoid any federal free-riding violations, which include freezing your trading account for 90 days. But some investors continue to observe the older three-day rule as a preference, although it's no longer a requirement.
Exploring Three-Day Settlements
When you buy or sell a stock in the U.S., you start a chain reaction that formerly took three days to complete. The SEC calls this “trade date plus three days settlement," also known as "T+3 settlement cycle." Though you own stock as soon as you buy it, the shares didn'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.
Amending to Two-Day Settlements
In 2017, the SEC amended the T+3 settlement cycle to a T+2 settlement cycle, effectively shortening the three-day rule to a two-day rule. The SEC's goal in changing this time frame was threefold: it more closely aligns with new technology, new products and the growth of trading volumes.
Understanding Free-Riding Violations
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 $100 in your cash account, and you purchase $1,000 of ABC stock on Monday (day zero, the trade date).
The remaining $900 you need to pay for this trade is due on Wednesday (day two, the settlement date). But the day prior to this settlement date (Tuesday), you sell this same security shares for $1,500. Because you've sold this stock before you've fully paid for it, your sale is a free-riding violation.
Consequences of Free-Riding Violations
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.
Video of the Day
- BananaStock/BananaStock/Getty Images