When trading in a cash account, understand the three different types of cash account violations you could encounter: free ride violation, good faith violation, and liquidation violation.
Many new investors start out using cash in a brokerage account; after all, it’s the simplest way to get going. Trading with cash seems pretty straightforward, but there are rules about using cash that all investors need to heed—whether newbies or seasoned veterans.
The rules have to do with stock settlement times and making sure you have 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 two days, known as T+2.
Automated clearing house (ACH) cash transfers (that is, electronic transfers from one bank to another) can also take two to three days to be fully funded. Knowing these settlement times is critical to avoiding violations. Otherwise, your trading account could be subject to temporary restrictions, explained Brandon Herman, senior manager, margins clearing at TD Ameritrade.
Let’s look at the three types of cash trading account violations and how they could occur.
A free ride violation occurs when you arrange to put money in your trading account and immediately buy securities, but for whatever reason, the funds don’t arrive. The most common cause of free riding is when someone tries to transfer funds, but there’s an issue at the bank and the money is returned, Herman explained.
Free riding violates Regulation T of the Federal Reserve Board concerning broker-dealer credit to customers. How can it happen? Suppose that:
The rules on free ride violations are strict, Herman explained. If this happens just once during a 12-month period, a client will 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 occur when clients buy and sell securities before paying for the initial purchases in full with settled funds. Only cash or proceeds from a sale are considered settled funds. Here’s an example of a good-faith violation:
Herman noted that if this happens three times in a 12-month period, a client will 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. Herman laid out how this violation occurs:
If this happens three times in a rolling 12-month period, Herman said that a client will be restricted to trading with settled cash for 90 days.
Qualified margin accounts can get up to twice the purchasing power of a cash account when buying a marginable stock, but with added risk of greater losses.
Learn the potential benefits and risks of margin trading.
There’s a way to reduce the likelihood of a violation like one of the scenarios above, Herman explained, and that’s to have a margin account to help cover any shortfalls.
Most people assume margin accounts are for borrowing money to put on large positions, because margin accounts allow traders to fund up to 50% of their securities purchases.
That’s true, but as Herman pointed out, it’s only one way to view a margin account. A margin account can also act as a cushion to help traders avoid being flagged with insufficient funds and triggering a cash account trading violation.
“In a cash account, if you buy and you sell, you have to wait for that sale to settle before you can use the funds again. Some clients may find it worthwhile to use a margin account every now and then to be able to buy what they want to buy, when they want to buy it, and borrow with margin for a short period of time,” he said.
Margin trading increases risk of loss and includes the possibility of a forced sale if account equity drops below required levels. Margin is not available in all account types. Margin trading privileges subject to TD Ameritrade review and approval. Carefully review the Margin Handbook and Margin Disclosure Document for more details. Please see our website or contact TD Ameritrade at 800-669-3900 for copies.
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