Cash account trading and free ride restrictions
- What is a cash account?
A cash account is defined as a brokerage account that does not allow for any extension of credit on securities. This includes retirement accounts and other non-retirement accounts that have not been approved for margin. While customers may purchase and sell securities with a cash account, trades are only accepted on the basis of receiving full payment in cash for purchases and good delivery of securities for sales by the trade settlement date.
If a cash account customer is approved for options trading, the customer may also purchase options, write covered calls, and cash covered puts.
Short selling, uncovered option writing, option spreads, and pattern day-trading strategies all require extension of credit under the terms of a margin account and such transactions are not permitted in a cash account.
- What are the rules surrounding cash account trade settlements?
Rules for payment of securities transactions executed in accounts are established under Federal Reserve Board Regulation T. Under these guidelines, purchases in cash accounts can be accepted under the following conditions: if there are sufficient funds in the account to fully pay for the purchase at the time the trade is executed or the customer makes a good faith agreement to promptly make full payment for the purchase on or before the settlement date and before selling the security.
Settlement datemay vary by security type and conditions of the trade but is generally two business days for equities and one business day for options and most mutual funds. Fixed income security settlement will vary based on security type and new issue versus secondary market trading.
It is important to note that the definition of sufficient funds in a cash account does not include cash account proceeds from the sale of a security that has not settled. It also does not include non-core account money market positions.
- What are possible cash account violations?
A good faith violation occurs when a security purchased in a customer's cash account is sold before being paid for with the settled funds in the account. This is referred to as a "good faith violation" because while trade activity gives the appearance that sales proceeds will be used to cover purchases (where sufficient settled cash to cover these purchases is not already in the account), the fact is the position has been liquidated before it was ever paid for with settled funds, and a good faith effort to deposit additional cash into the account will not happen.
Good faith violation example 1:
Cash available to trade = $0.00- On Monday morning, a customer sells XYZ stock netting $10,000 in cash account proceeds.
- On Monday afternoon, the customer buys ABC stock for $10,000.
- If the customer sells ABC stock prior to Tuesday (the settlement date of the XYZ sale), the transaction would be deemed to be a good faith violation because ABC stock was sold before the account had sufficient funds to fully pay for the purchase.
Good faith violation example 2:
Cash available to trade = $10,000, all of which is settled- On Monday morning, the customer purchases $10,000 of XYZ stock.
- On Monday mid-day, the customer sells the XYZ stock for $10,500.
- At this point, no good faith violation has occurred because the customer had sufficient funds (i.e. settled cash) for the purchase of XYZ stock at the time the purchase was made.
- Near market close, the customer purchases $10,500 of ABC stock.
- A good faith violation will occur if the customer sells the ABC stock prior to Tuesday when Monday's sale of XYZ stock settles and the proceeds of that sale are available to fully pay for the purchase of ABC stock.
A cash liquidation violation occurs when a customer purchases securities and the cost of those securities is covered after the purchase date by the sale of other fully paid securities in the cash account.
Cash liquidation violation example 1:
Cash available to trade = $0.00- On Monday, the customer purchases $10,000 of ABC stock.
- On Tuesday, the customer sells XYZ stock, which had been purchased the previous month, for $12,500 in proceeds (due to settle on Friday).
- A cash liquidation violation has occurred because the customer purchased ABC stock by selling other securities after the purchase. When the ABC transaction settles on Tuesday, the customer's cash account will not have the sufficient settled cash to fund the purchase because the sale of the XYZ stock will not settle until Wednesday.
A free riding violation occurs when a customer purchases securities and then pays for the cost of those securities by selling the very same securities.
Free riding example 1:
Cash available to trade = $0.00- On Monday morning, the customer places an order to purchase $10,000 of ABC stock through a representative on a good faith agreement of prompt payment by settlement date (Tuesday).
- No payment is received by settlement on Tuesday.
- On Wednesday, the customer sells ABC stock for $10,500
A free riding violation has occurred because no payment was received for the purchase.
Free riding example 2:
Cash available to trade = $5,000- On Monday morning the customer places an order to purchase $10,000 of ABC stock intending to send $5,000 payment later in the week (before Tuesday) through an electronic funds transfer.
- Later in the day Monday, ABC stock rises dramatically in value due to rumors of a takeover.
- On Tuesday, the customer sells ABC stock for $15,000 and decides it is no longer necessary to send the $5,000 payment.
- The customer does not complete the electronic funds transfer.
- A free riding violation has occurred because the $10,000 purchase of ABC stock was paid for, in part, with the sale of ABC stock since the customer did not deposit into the account the additional $5,000 to cover the purchase price of ABC stock by settlement date.
A cash account with three good faith violations, three cash liquidation violations or one free riding violation in a 12-month period will be restricted to purchasing securities only when the customer has sufficient settled cash in the cash account at the time of purchase. This restriction is effective for 90 calendar days.
- What is my balance for cash available to trade?
Cash available to trade is defined as the cash dollar amount available for trading in the core account without adding money to the account. This balance includes intraday transaction activity.
For unrestricted cash accounts, all buy trades are debited and all sell trades are credited from the cash available to trade balance as soon as the trade executes, not when the trade settles. For example, if the core is $10,000, a deposit of $10,000 is received today, and the account has a $10,000 credit balance from unsettled activity, the cash available to trade balance would be $30,000.
For cash accounts restricted for free riding or good faith violations, the cash available to trade balance will not include unsettled cash account sale proceeds.
