Take a moment and think about if there were no laws surrounding motor vehicles. You could go whatever speed you liked and if you hit someone else from your own negligence that than person would be SOL. Personally, I would drive straight to Vin Diesel’s house and challenge him to a street race. Winner gets to star in Fast and Furious 37 (At this pace we’ll be there in a couple years). All fantasies aside if this was actually the case then there would be pure chaos in the streets. If there was no control, there would be many accidents and many people would be injured or killed because of it. The same sorts of risk can be applied in trading as well. Don’t me wrong no one is going to get injured physically, but financial blows people could take are a very real possibility. For this reason, there are rules in place to protect you and to protect brokerage firms. You need to understand the rules of the game before you play.
There are two classifications of accounts that you can have. A cash account and a margin account. In this article, I’m going to be discussing trade violations that can occur in a cash account. I will discuss margin accounts in another lesson. Let’s dive right in.
When you buy or sell a stock it takes the trade date plus 3 business days for that trade to fully settle. Let’s say I own some Disney stock and I want to sell some of it so I can use the money to pay for a new TV. I sell Disney on Monday October 24th. Those funds will be fully liquid and available to withdrawal on Thursday October 27th. Remember trade date plus 3 business days or T+3.
Another example we could look at on the buy side. I currently do not have any liquid cash in my account but I plan to deposit a check for $5,000 dollars tomorrow. I really want to buy some Disney stock because the price is perfect for me right now. Can I still buy this stock with no cash? Yes. You have until settlement to deposit funds into the account. This means that the funds from your check will cover the trade.
*With mutual funds the settlement is T+1, trade date plus one business day. Mutual funds are more liquid than stocks because of this reason.
Good Faith Violation
Travel back in time to the 3rd grade. You are sitting at the lunch table and you offer to sell Jimmy your lunch that your mom packed you. Jimmy agrees and says he will pay you with lunch money he will get in 3 days. The very next day you see Mike has a lunch packed with a bag of Cheetos. You know that Bob loves Cheetos and you decide that you can buy them from Mike and sell them to Bob. The problem is Jimmy still hasn’t paid you yet so you don’t have any money. You buy the Cheetos from Mike anyway and tell him you’ll get him the money soon. Then you sell those Cheetos to Bob that same day and he gives you some money to pay for them. This would be known as a good faith violation. It is essentially using unsettled funds to buy and sell a stock. Let’s use a stock example instead of Mikes Cheetos.
- Cash available to trade = $0.00
- On Monday morning, a you sell Disney stock in your account netting $10,000 in cash account proceeds
- On Monday afternoon, the you buy Apple stock for $10,000
- If you sell Apple stock prior to Thursday (the settlement date of the Disney sale), the transaction would be deemed to be a good faith violation because Apple stock was sold before the account had sufficient funds to fully pay for the purchase
Free Ride Violation
A free ride occurs when you buy and sell a stock without depositing any funds into the account. Example:
- Cash available to trade = $0.00
- On Monday morning, you place an order to purchase $10,000 of Disney stock through a representative on a good faith agreement of prompt payment by settlement date (Thursday).
- No payment is received by settlement on Thursday.
- On Friday, you sell Disney stock for $10,500
- A free riding violation has occurred because no payment was received for the purchase
- Cash available to trade = $5,000
- On Monday morning, you place an order to purchase $10,000 of Disney stock intending to send $5,000 payment later in the week (before Thursday) through an electronic funds transfer
- On Tuesday, Disney stock rises dramatically in value due to high revenues from the new Star Wars movies.
- On Wednesday morning, you sell Disney stock for $15,000 and decides it is no longer necessary to send the $5,000 payment.
- A free riding violation has occurred because the $10,000 purchase of Disney stock was paid for, in part, with the sale of Disney stock since you did not deposit into the account the additional $5,000 to cover the purchase price of Disney stock by settlement date.
Settled Cash Up Front Restriction (SCUF)
Different brokerage firms are going to have different policies on the consequences for these violations. Most commonly, you will have 1 get out of jail free card. They will treat your first violation as a slap on the wrist and make it an education opportunity. The next one you receive will put a settled cash up front restriction on your account.
- This means that you will have to have settled funds in order to buy any more stock positions.
- This is on the account for 90 calendar days.
- If you have 3 of these violations within a 12-month period, your account will have a permanent settled cash up front restriction.
o This means you will always have to wait for settled funds to buy another stock
o This permanent SCUF follows you from firm to firm
Always be aware of these settlement dates and the available liquid cash in your account. When you mock up a trade there will be an “available to trade” section that will show you your liquid funds. If a stock has not settled yet, then those funds will not show in this section. You can always contact your brokerage firm if you are unsure about the settlement. The best solution to avoid the headache of keeping up with settlement dates is having a margin account. Margin accounts are great for that purpose but they have their own set of rules as well. Like I said I’ll be covering that in another article so stay tuned!
“You have to lean the rules of the game, and then you have to play better than anyone else.” -Albert Einstein
Homework: Hypothetically pick 3 stocks to trade on random days of the week. Determine what their settlement date is going to be and keep in mind weekend and holidays.