When day trading stocks or other securities in a cash account, it is important to know the rules to avoid possible violations. This includes a Good Faith Violation.
Before making your first day trade, you’ll need to decide whether you plan to trade on a margin basis or in a cash account.
Today, we are going to take a look at cash accounts and the good faith violation (GFV) that applies to these types of accounts.
What is a cash account?
If you want to buy and sell stocks, one of the first steps is to open an account with a reputable online broker.
Examples of popular U.S. brokerage firms include Lightspeed, Robinhood, Ameritrade, E-Trade, Charles Schwab, TradeStation, Interactive Brokers, to name but a few.
Once you have picked your broker, you are given two options: margin or cash accounts.
A margin account is a type of trading account that allows you to buy stocks on margin by borrowing money through your broker.
With a margin account, you will have up to twice the purchasing power of a cash account, which will give you the opportunity to trade larger sizes and generate more profits.
A cash account is pretty simple. With this account, you can only trade with the money you have on hand. Unlike margin accounts, you can’t borrow money from your broker using cash accounts.
For example, if you have $1,000, you can only buy $1,000 worth of stocks, and can’t use the stocks in your cash account as collateral to borrow more money from your broker.
While a cash account doesn’t give you as much purchasing power, one of the biggest advantages of using this type of account is that you can help prevent large losses, more so if you are an active trader.
Before we dig deep into good faith violations, it is important to explain how stocks or other securities are paid for. When you buy or sell a stock, your trade takes place immediately.
However, even though your newly purchased stock now appears in your brokerage account, the trade is not settled. Market rules allow a few days (settlements) for a transaction to be deemed official.
The settlement date refers to the date when a trade is final and the buyer must make payment to the seller while the seller passes the security to the buyer.
For options and government securities, the settlement date is usually the next business day (T+1). For stocks and bonds, it is two trading days after the execution date (T+2).
What is a good faith violation?
A good faith violation occurs when you buy a stock and sell it before the funds that you used to make the purchase have settled. Only sales proceeds of fully paid for securities or cash qualify as settled funds.
The reason why liquidating a position before it was ever paid for with settled funds is called “good faith violation” is because there was no effort in good faith to deposit necessary cash into the account before the settlement date.
What is a good faith violation example?
The following examples demonstrate how a hypothetical trader (Jim) might incur good faith violations.
Let’s say Jim has $0 in his cash account.
On Monday morning, he sells Apple (AAPL) stock and generates $5,000 in cash account proceeds. Later in the afternoon, Jim buys Tesla (TSLA) stock for $5,000.
If he sells TSLA stock prior to Wednesday (the settlement date of the AAPL sale), the transaction would be considered a good faith violation since he sold TSLA stock before the account had enough funds to fully cater for the purchase.
Let’s assume that the cash available to trade in Jim’s cash account is $1,000 minus cash credit from unsettled activity = $500 (proceeds from a sale of stock the prior Friday – trade settles on Tuesday)
Jim buys $1,500 of TSLA stock on Monday morning. If he sells the stock later that day, a good faith violation will have occurred.
The purchase of the stock is not considered fully paid for since the $500 proceeds are not deemed enough funds until they are settled on Tuesday.
Suppose Jim has a settled cash balance of $2,000. He then buys $2,000 of TSLA stock on Monday morning.
Later in the afternoon, he sells the stock for $2,500. When the market is about to close, Jim buys $5,500 of AAPL stock.
At this point, no good faith violation has happened because he had sufficient funds for the purchase of the TSLA stock. But, if he sold the AAPL stock before being paid (settlement), then a good faith violation will have happened.
Consequences of good faith violations
When a good faith violation occurs, your broker will notify you that a violation has occurred and explain the consequences if it occurs two more times. The message will also include steps on how to avoid GFV in the future.
If you incur three good faith violations within 12 months in a cash account, your broker will restrict your account for a period of 90 days.
This means you will only be allowed to buy stocks if you have fully settled cash in the account prior to placing a trade.
How to avoid good faith violations
The easiest way to avoid good faith violations is to make sure that you are only ever buying stocks with settled funds.
Another great way to avoid any issues is to always wait at least two trading days after you buy a stock before you sell it.
A trading day refers to any day that the New York Stock Exchange (NYSE) and the NASDAQ are open for trading.
While cash accounts are not subject to pattern day trading rules, they are subject to the good faith violation that falls under the U.S. Federal Reserve Board Regulation T.
This regulation was initially formulated to govern margin accounts but was later extended to govern transactions for cash accounts as well.
Since stock trades held less than two days in cash accounts require settled funds to avoid good faith violations, it is advisable to wait at least two days between trades to avoid executing the short-term trades or day trades with unsettled funds.
Limiting day trades to settled funds can greatly help minimize the risk of incurring good faith violations.