You buy a stock Monday morning, sell it for a profit Monday afternoon, and use those proceeds to buy another stock. Sounds like a normal day trade, right? But if you have a cash account, you may have just committed a free riding violation. This common mistake can get your account restricted for 90 days.
What Is a Free Riding Violation?
Free riding occurs when you buy securities, sell them before paying for the original purchase, and then use the sale proceeds to pay for the original purchase. In simpler terms, you are using money you do not technically have yet because stock trades take time to settle.
The core issue: When you sell a stock, the money from that sale takes two business days to settle (T+2). If you use unsettled funds to buy a stock and then sell that new stock before the original funds settle, you have committed a free riding violation.
Understanding Settlement Periods
The settlement period is the time between when a trade is executed and when it officially completes. For most securities in the United States:
- Stocks: T+2 (trade date plus two business days)
- Options: T+1 (trade date plus one business day)
- Government bonds: T+1
- Mutual funds: Varies, typically T+1 or T+2
How Free Riding Violations Happen
Let us walk through a specific example of how this violation occurs:
Free Riding Example
You have a cash account with $5,000 in settled cash.
- Monday: You buy $5,000 of Stock A
- Monday (later): You sell Stock A for $5,200
- Monday (even later): You buy $5,200 of Stock B using the unsettled proceeds
- Tuesday: You sell Stock B for $5,400
- Problem: You sold Stock B before the original $5,000 settled
You used the unsettled proceeds from Stock A to buy Stock B, then sold Stock B before Stock A's settlement completed. This is free riding.
The Consequences of Free Riding
Free riding violations carry serious consequences:
- 90-day restriction: Your account may be restricted to trading only with settled cash for 90 days
- No margin privileges: If you had margin, it may be revoked
- Repeated violations: Can lead to account closure
- Permanent record: Violations stay on your account history
Important distinction: Free riding violations only occur in cash accounts. Margin accounts have different rules that allow you to trade with unsettled funds, which is one reason active traders often use margin accounts.
Free Riding vs. Good Faith Violation
These two violations are related but different:
- Good faith violation: Buying a security with unsettled funds and selling it before those funds settle
- Free riding violation: A more severe version where you never actually had the settled funds to cover the initial purchase
Good Faith Violation Example
You have $2,000 settled and $3,000 unsettled.
- You buy $4,000 of stock (using $2,000 settled + $2,000 unsettled)
- You sell the stock before your unsettled $3,000 clears
- This is a good faith violation, not free riding
Good faith violations typically result in a warning for first offense, with restrictions after three violations in a 12-month period.
How to Avoid Free Riding Violations
Follow these practices to keep your account in good standing:
- Track your settled cash: Always know how much settled cash you have available
- Wait for settlement: If you sell a stock, wait two business days before using those proceeds to buy and sell again
- Use a margin account: Margin accounts do not have free riding restrictions
- Keep cash reserves: Maintain extra settled cash to cover trades while waiting for settlement
- Check your broker's tools: Most brokers show settled vs. unsettled cash clearly
Why Margin Accounts Solve This Problem
With a margin account, you can trade freely without worrying about settlement periods because:
- The broker essentially lends you money to trade while waiting for settlement
- You can buy, sell, and buy again all in the same day
- Settlement still happens in the background, but it does not restrict your trading
Margin account requirements: You typically need at least $2,000 to open a margin account. If you plan to day trade frequently, you will need $25,000 to avoid pattern day trader restrictions.
What Happens If You Get Restricted
If you receive a free riding restriction, here is what to expect:
- You can still trade, but only with fully settled funds
- You must wait for each sale to settle before using those funds again
- The restriction lasts 90 days from the violation date
- Some brokers may lift the restriction early with a deposit of new funds
Practical Tips for Cash Account Traders
If you must use a cash account, follow these strategies:
The Rotation Strategy
Divide your cash into three portions:
- Day 1: Trade with Portion A
- Day 2: Trade with Portion B (Portion A is settling)
- Day 3: Trade with Portion C (Portions A and B are settling)
- Day 4: Portion A is now settled and available again
This rotation ensures you always trade with settled funds.
Common Misconceptions
Clear up these misunderstandings about free riding:
- "I can trade freely if I make money" - Wrong. Profitability does not matter; the timing of settlement does.
- "Options settle faster so I am safe" - Options are T+1, but you can still violate if you are not careful.
- "My broker should stop me" - Some brokers do prevent violations, but not all. It is your responsibility.
- "It is just a warning" - Free riding can result in immediate 90-day restriction, not just a warning.
When to Consider Upgrading to Margin
Consider switching to a margin account if:
- You trade more than a few times per week
- You have at least $2,000 to meet margin minimums
- You want flexibility to react quickly to market opportunities
- You understand the additional risks margin creates
Track All Your Trading Activity
Pro Trader Dashboard helps you monitor your trades and understand your trading patterns. Keep track of your activity across accounts to stay compliant with trading rules.
Summary
Free riding violations occur when you use unsettled funds to buy securities and sell them before the original funds settle. This can result in a 90-day restriction on your cash account. To avoid this, track your settled cash carefully, wait for settlement before reusing funds, or consider upgrading to a margin account. Understanding settlement rules is essential for any active trader using a cash account.
Want to learn more about trading rules? Read about margin trading or learn about the day trading rules for beginners.