If you are investing at a faster pace, you can sometimes come up against what’s called a Cash Account Violation. This is exactly what it sounds like, and means that you’re not exactly following the rules of a cash account.
"Good Faith" Violation
The good faith rule indicates that you can’t do an operation with money that is not yet yours, that has not reached your property. A good faith violation occurs when you purchase 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.
✍️ An example of a good faith violation would be if an individual sells a stock and receives $10,000 in cash account proceeds on a Monday morning, then buys a different stock for $10,000 on the same Monday afternoon. If the individual sells the second stock prior to Wednesday (the settlement date of the first sale), the transaction would be considered a good faith violation because the second stock was sold before the account had sufficient funds to fully pay for the purchase.
If you incur three good faith violations in a 12-month period, our clearing firm may restrict your account. This means you will only be able to buy securities if you have sufficient settled cash in your account prior to placing a trade, and this restriction will be effective for 90 calendar days.
"Free Riding" Violation
Free riding violation refers to the illegal practice of buying securities and then paying for that purchase by using the proceeds from a sale of the same securities. This violates Regulation of the Federal Reserve Board.
✍️ For example, if a trader has no cash available to trade, he buys $10,000 of ABC stock, but does not pay for it by the settlement date, and then sells the stock for $10,500 to cover the cost of his purchase, he will be in violation of free riding. Similarly, if he has $5,000 cash available to trade, buys $10,000 of ABC stock, but sells the stock for $15,000 before sending the $5,000 payment, he also incurs a free riding violation.
If a trader incurs one free riding violation in a 12-month period in a cash account, their brokerage firm will restrict their account, meaning they will only be able to buy securities if they have sufficient settled cash in the account prior to placing a trade, and this restriction will be effective for 90 calendar days. To avoid these restrictions, traders should maintain sufficient settled funds to pay for purchases in full by settlement date.
Do you have any additional questions regarding Good Faith Violation and Free Riding? You can contact our support team here. We're here to help!