Freeriding Definition: Day Trading Terminology
To be a successful day trader, skill, discipline and training are among the most important attributes that one has to possess. Every trader has goals they would love to attain. Some of the goals include attaining good returns, minimizing risks and compounding growth.
To ensure every trader has a fair leverage when interacting with the market, rules and regulations are needed. Understanding the rules and regulations that govern brokerage accounts and trading will help you avoid running into problems.
Before you place the first trade, it’s wise to decide whether you want to trade with cash or margin account. In cash account, traders buy securities and settle the transaction with cash before selling the security while in margin account; traders can borrow from the brokerage firm against buy and sell orders.
Today, we will discuss free riding, a violation pertaining to trading with cash account.
What Is Free Riding?
This is a trading violation, also called a good faith violation, where a trader’s account is frozen as a result of purchasing a security and selling it before paying for it in cash. It happens when you sell a stock in a cash account and then use the unsettled funds to purchase another stock but before the funds settle you close the new purchase. Under the Federal Reserve Board Regulation T, free riding is not permitted and as said earlier, it results in the trader’s account being frozen by the investor’s broker.
The cash account is frozen for 90 days but traders have the chance of purchasing securities with the account. To ensure that an investor is not penalized any further, the investor/trader must settle the purchase on the day of the trade.
In day trading, freeriding describes an instance where an investor purchases a security and sells it within an hour before settling the original purchase. This happens when the investor does not have funds to cover the settlement of the trade at the time of the purchase. The purchase of any security is known to take three business days to settle funds via the brokerage firm. When a purchase is made, the available balance will change immediately but the brokerage firm will officially settle the purchase after three days.
This simply means that as a free rider, you are selling a stock that you don’t own officially. Under SEC Regulation T and NYSE Rule 431, this type of transaction is prohibited to investors and brokerage firms.
Imagine this, if you were to purchase $500 of Company A stock valued at $20 on Monday, you will be required to have $10,000 in free cash to settle the transaction. On Tuesday, Company A stock rises to $25 which means you will earn a total of $12,500. The problem is you did not settle the original trade without the proceeds of the new sale. If an investor is unable to settle the original trade, then they are free riding.
How It Affects Your Account
As said earlier, SEC’s Regulation T requires the investor’s broker to freeze the investor’s account for a period of 90 days. Despite the freeze, the investor can still use the cash account to trade but they must settle all purchases on the date of trade.
SEC has brought successful criminal prosecutions against free riders where significant prison sentences have been imposed. This has happened for both credit and anti fraud violations. A good example is the case between SEC v Schlomo Teitelbaum.
Investors can avoid having their accounts being frozen by fully paying for every single purchase on the settlement date with funds not derived from the sale of the securities.
What you ought to know is that your broker’s trading software will warn you when getting close to freeriding. The problem is the warnings are cryptic and you may end up missing the signal. If you are in doubt, it is highly advisable to contact your broker. This will help in preventing the freezing of your account for 90 days.