Freeriding in the stock market refers to the practice of buying and selling securities within a cash account without having sufficient settled funds to cover the initial purchase. Essentially, it’s using the proceeds from the sale of a security to pay for its own purchase, creating an illusion of having the necessary funds. This practice is prohibited by regulatory bodies like the Financial Industry Regulatory Authority (FINRA) and can lead to penalties, including account restrictions. Let’s delve deeper into what constitutes freeriding, explore some illustrative examples, and understand the consequences of engaging in this prohibited activity.
What Exactly is Freeriding?
Freeriding exploits the settlement period, which is the time between the trade date (when you buy or sell a security) and the settlement date (when the transaction is finalized and funds are exchanged). In a cash account, you are expected to have the full amount of cash available to cover your purchases by the settlement date. Freeriding occurs when you buy a security and then sell it before the initial purchase has settled, effectively using the proceeds from the sale to pay for the buy. This creates a situation where you haven’t actually used your own funds to cover the initial transaction.
Examples of Freeriding Scenarios
Several scenarios can illustrate how freeriding occurs. These examples will help clarify the concept and demonstrate how seemingly innocent trading activities can result in a violation.
Scenario 1: Selling to Cover the Initial Purchase
Imagine you have $3,000 in your settled cash balance. You decide to purchase stock for $4,000. Later that same day, the stock price increases, and you sell it for $4,500. While it might appear that you’ve made a profitable trade, you’ve actually committed a freeriding violation. You used the $4,500 from the sale to effectively cover the $4,000 purchase, even though you didn’t have the necessary funds in your account at the time of the initial buy.
Scenario 2: Multiple Purchases and Sales Leading to a Freeride
Let’s say you have $3,000 in settled funds. You purchase Stock X for $3,000 and Stock Y for an additional $1,000. Later that day, you sell the shares of Stock X without adding any more cash to your account. This also constitutes freeriding. The total purchase amount for the day ($4,000) exceeded your available settled funds ($3,000), and you used the proceeds from the sale of Stock X to cover a portion of that cost.
Scenario 3: Utilizing Unsettled Funds for Purchases
Consider a situation where you have a zero balance in your settlement fund and no pending credits or sales proceeds. On Monday, you sell Stock A, expecting the cash proceeds to settle in your account on Tuesday. On the same Monday, you buy Stock B, with payment due on Tuesday. However, also on Monday, you sell Stock B. Even though you anticipate having the funds from the sale of Stock A by Tuesday, you’ve still committed a freeride. You’ve effectively used the unsettled funds from the sale of Stock A to cover the purchase of Stock B, which is against regulations.
Penalties for Freeriding
The penalty for freeriding is typically a 90-day restriction on your trading account. During this restriction period, you are required to have settled funds available in your account before making any new security purchases. This means you cannot rely on unsettled funds or proceeds from same-day sales to cover your buys. This restriction is designed to ensure that traders adhere to regulations and maintain the integrity of the market.
Frequently Asked Questions about Freeriding
Here are some common questions about freeriding:
Q: What’s the difference between good faith violations and freeriding?
A: Good faith violations typically involve unintentional errors in calculating settled funds, while freeriding implies a deliberate attempt to trade without sufficient funds.
Q: How can I avoid freeriding violations?
A: Always ensure you have sufficient settled funds in your cash account before making any purchases. Monitor your account balance regularly and be aware of the settlement dates for your transactions.
Q: What should I do if my account is restricted due to freeriding?
A: Contact your brokerage firm immediately to understand the terms of the restriction and the steps required to reinstate full trading privileges.
Q: Can I appeal a freeriding restriction?
A: You can contact your broker or FINRA to discuss the specifics of your case and explore potential appeal options.
We encourage you to share your questions and experiences with freeriding in the comments section below. Understanding this important regulation can help you navigate the complexities of securities trading and avoid potential penalties.
