- A freeriding violation occurs when you buy a security using funds from the sale of the same security that hasn’t settled yet. In other words, it involves buying and selling securities without actually putting up your own money to cover the purchase.
- If you receive just one freeriding violation in a period of 12 months, your account will get restricted for 90 calendar days, and you will only be able to use settled funds to place new trades.
If you buy securities without having sufficient funds, and then sell those securities before depositing enough money to pay for them, a freeriding violation is triggered. Instead of purchasing the shares with your own money, you’re using the proceeds from the sale of the security.
A freeriding violation is a trading violation that many people confuse with the good faith violation. In this article, we’ll look at what a freeriding violation is, how it differs from a good faith violation, and how to avoid them while buying and selling equities through your cash account.
How do freeriding violations occur?
The most common reason for triggering freeriding violations is due to uncleared deposits. While the actual processing times depend on your bank, deposits usually take anywhere between 3 to 5 business days to settle into your brokerage account.
If you have deposits that haven’t settled, use it to purchase securities, then sell those securities before the funds ever make it to your account, you will incur a freeriding violation.
Note: The freeriding violation only occurs when you sell the shares without having paid for them. You’re allowed to purchase and hold equities purchased with unsettled funds. A violation is only triggered if you sell before you have sufficient settled funds in your account to fund the initial purchase.
Example of a freeriding violation
Let’s say that on Monday, you deposit $10,000 into your brokerage account and immediately use the entire amount to purchase shares of Stock A, without waiting for the funds to clear. On Wednesday, you discover that due to an issue at the bank, the deposit never cleared and was returned to your bank account. On Thursday, you sell your Stock A shares for $12,000, giving you a $2,000 profit. Because your deposit never cleared, you pay for the original purchase of Stock A shares with your proceeds from the sale, and pocket the $2,000 profit.
This is a freeriding violation because you bought and sold shares of Stock A without ever having paid for it with your own funds. You are technically “freeriding” the trade, which is a violation of Regulation T of the Federal Reserve Board.
Freeriding violation vs good faith violation
A freeriding violation looks similar to a good faith violation on paper, but there are some key differences that distinguish them from one another.
In a freeriding violation, you’re buying and selling equities without ever having enough money in your account to buy them in the first place. Instead, you’re using the sale of the security you purchased without your own money to fund the initial purchase.
In a good faith violation, you’re using unsettled funds from the sale of another security, and then selling those securities before the funds you used to pay for them have settled. The settlement date for stocks is two business days after the trading date, so if you’re using unsettled proceeds from another trade to place a new trade, you must wait until the funds have settled before selling.
How to avoid a freeriding violation
Freeriding violations come from selling, not buying. There are no violations for the act of buying securities with unsettled funds.
To avoid a freeriding violation, you need to settle your buy order separate from the activity of selling that security. Because you paid for the security with funds that never made it into your account, you must ensure you have enough settled cash to fund the buy order before you sell.
If you want to avoid any risks of freeriding violations, you can do so by only using settled funds in your account to place new trades.
Penalties for freeriding violations
If you receive just one freeriding violation in a period of 12 months, your brokerage will restrict your account and you will only be able to use settled cash to place new trades. A good faith violation has the same penalties, but you are given warnings for your first two violations.