When you’re trading in your cash account, there are 3 different types of violations that you need to be aware of.
- Good faith violation
- Freeriding violation
- Cash liquidation violation
With a cash trading account, you’re required to pay for all purchases in full by the settlement date, which is the day in which the trade becomes finalized. The settlement date is different from the actual trading date. When you sell a stock, the trade takes place immediately, but the settlement date for stocks is two business days after the trading date (T+2). That means if you sell a stock on Tuesday, the trade will take place immediately, but the proceeds from the sale will be considered “unsettled” until the settlement date on Thursday.
The different cash trading violations are all triggered by buying and selling stocks with unsettled cash and not having sufficient settled cash to fund the purchase before its settlement date.
Let’s go through each of them below.
Good faith violation
A good faith violation occurs when you buy securities with unsettled proceeds from another sale and then sell those securities before the funds used to purchase them have settled.
The most common good faith violation example looks something like this:
- On Monday, you sell $1,000 worth of Stock A in order to get cash to make a new trade.
- The same day, you use the $1,000 to purchase Stock B.
- The next day, on Tuesday, you sell your entire position of Stock B.
This would be a good faith violation because you purchased Stock B with funds from the sale of Stock A, and then sold Stock B before the proceeds from the Stock A reached its settlement date. You’re liquidating a position before it was ever paid for with settled funds.
Freeriding violation
A freeriding violation occurs when you buy securities without ever having sufficient settled funds in your account, and then pay for the purchase with the proceeds from the sale of the same securities. It’s a little difficult to understand with just a definition, so let’s go through an example.
The most common freeriding violation example looks something like this:
- On Monday, you have $0 in settled cash in your account and you decide to make a deposit of $1,000. The deposit will take 3 to 5 business days to clear, but you use the funds to purchase $1,000 worth of Stock A.
- Since you purchased the stock Monday, the settlement date is Wednesday. In a cash trading account, you must pay for all purchases in full by the settlement date.
- However, the deposit never makes it into your account by the settlement date.
- You decide to sell Stock A in order to cover the purchase.
This would be a freeriding violation because you never had the money to purchase Stock A in the first place, and are now using the proceeds from the sale of Stock A in order to fund the initial purchase.
Cash liquidation violation
A cash liquidation violation occurs when you buy securities and cover the cost the purchase by selling a different fully paid for security after the purchase date. It looks a lot like a mixture of a good faith violation and a freeriding violation.
The most common cash liquidation violation example looks something like this:
- On Monday, you have $0 in settled cash in your account, but you purchase $1,000 worth of Stock A.
- Since you purchased the stock Monday, the settlement date is Wednesday. In a cash trading account, you must pay for all purchases in full by the settlement date.
- On Tuesday, you decide to sell $1,000 worth of another stock you own, Stock B, in order to pay for the purchase of Stock A before the settlement date.
This would be a cash liquidation violation because the proceeds you used from the Stock B sale are not settled funds. You sold Stock B on Tuesday, so the settlement date for that trade is Thursday. However, you used those proceeds to fund your purchase of Stock A.
Penalties for cash trading violations
The penalties are the same for all three types of cash trading violations. However, good faith violations and cash liquidation violations give you two warnings before the penalty is implemented. With a freeriding violation, there is no warning and you’re penalized immediately.
Good faith violation penalties: If you incur 3 good faith violations in a period of 12 months, your account will get restricted for 90 days, and you will only be able to trade using settled funds.
Freeriding violation penalties: If you incur just one freeriding violation in a period of 12 months, your account will get restricted for 90 days, and you will only be able to trade using settled funds.
Cash liquidation violation penalties: If you incur 3 cash liquidation violations in a period of 12 months, your account will get restricted for 90 days, and you will only be able to trade using settled funds.
Conclusion
All three types of cash account violations are triggered from buying securities with unsettled cash (money you never had) and then selling them before you had sufficient settled cash to fund the sale.
- In a good faith violation, you’re using unsettled proceeds from another sale in order to fund the purchase of new securities. If you sell those securities before the funds used to purchase them have settled, it would trigger a violation.
- In a freeriding violation, you’re using money that never existed in your account (or never made it to your account) to purchase securities, and then selling those securities to fund the purchase.
- In a cash liquidation violation, you’re using money that never existed in your account (or never made it to your account) to purchase securities, and then selling a different fully paid for security in order to fund the initial purchase.
All three violations can be 100% avoided by only using settled funds to trade in your cash account. If you’re using unsettled funds to make trades, make sure that you always have enough settled funds to fund the purchase by the settlement date.
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