Avoid These Violations When Trading Cash

Many new investors start out trading in a cash account instead of a margin account; after all, it's the simplest way to start. In a cash account, investors must pay for securities in full. An investor using a cash account is not allowed to borrow funds to pay for transactions in the account (that would be trading on margin).

Trading in a cash account seems straightforward, but there are rules that all investors need to heed—whether newbies or seasoned veterans.

The rules pertain to stock settlement times and making sure you've settled cash in your cash account to pay for purchases.

Different trading products can have different settlement times, but the standard for equities is the trade date plus one day, known as T+1. This one-day settlement date applies to most security transactions, including stocks, bonds, municipal securities, mutual funds traded through a brokerage firm, options, government securities, and limited partnerships that trade on an exchange.

Automated clearing house (ACH) cash transfers—that is, electronic transfers from one bank to another—can take two to three business days to be fully credited to your account. Knowing these settlement times is critical to avoiding violations. Otherwise, your trading account could be subject to temporary restrictions.

Let's review three examples of cash trading account violations and how they could occur.

In a cash account, an investor must pay for the purchase of a security before selling it. If an investor buys and sells a security before paying for it, then the investor is "freeriding." The most common cause of freeriding is when someone tries to transfer money but there's an issue at the bank and—for whatever reason—the cash doesn't arrive.

Freeriding violates Regulation T of the Federal Reserve Board¹ concerning broker-dealer credit to customers. Here's an example:

• On Friday, Joe deposits $10,000 in a brokerage account.
• On Monday, Joe places a trade for XYZ with that $10,000 without waiting for the money to clear.
• On Tuesday, the $10,000 is returned to Joe's bank, meaning he never paid for the original trade.
• On Wednesday, Joe sells XYZ for a profit despite never paying for the original trade.

The rules on freeride violations are strict. If this happens just once during a 12-month period, a client could be restricted to using settled cash to place trades for 90 days. Profits from the trade may be seized, and any losses incurred by the trades are the client's responsibility.

Good faith violations happen in a cash account if an investor buys a stock with unsettled funds and liquidates it prior to settlement. Only cash or proceeds from a sale are considered settled funds. Here's an example of a good faith violation:

• On Monday, Janet holds $10,000 worth of XYZ.
• On Tuesday morning, Janet sells her entire XYZ position for $10,500, which will settle Wednesday morning.
• Later Tuesday morning, Janet buys $10,500 of FAHN on good faith that XYZ's sale will settle.
• On Tuesday afternoon, Janet sells FAHN for $11,000, making a $500 profit. However, FAHN's original purchase wasn't fully paid for because XYZ's sale hadn't yet settled.

If this problem happens three times in a 12-month period, a client could be restricted to trading with settled cash for 90 days.

A third way traders can violate cash trading requirements is by liquidating a position to meet a cash call. This happens when there isn't enough settled cash in a brokerage account to cover purchases on a settlement date. Here's how this kind of violation occurs:

• On Monday, Pat deposits $10,000 in a brokerage account.
• On Tuesday, Pat buys $10,000 worth of XYZ stock. Later that day the deposit bounces and is returned to the bank.
• On Wednesday morning, the brokerage firm contacts Pat, requesting the cash to pay for the purchase of XYZ.
• On Wednesday afternoon, Pat sells FAHN stock for $10,500 to pay for XYZ's purchase and meet the cash call. However, Pat's purchase of XYZ settled on Wednesday and FAHN's sale settles on Thursday, so the purchase remains unpaid.

If this happens three times in a rolling 12-month period, a client could be restricted to trading with settled cash for 90 days.

Investors using a cash account should make sure they have enough cash in the account to cover all purchases. Violating the rules of trading in a cash account can result in your account being restricted.

One way to reduce the likelihood of a cash violation like those described above is to establish a margin account to cover potential shortfalls. When trading in a margin account, you can use funds that have not yet settled and avoid cash violations without incurring interest, but that's dependent on sufficient funds settling in your account. Margin trades will incur interest when a trade exceeds the settled funds and that debit balance is carried overnight.

Margin isn't suitable for everyone, though, and is not available in all account types. Margin trading increases risk of loss and includes the possibility of a forced sale if account equity drops below required levels. Regardless of which type of account you use, make sure you understand when your trades settle and monitor them closely.