Trading with cash? Avoid account breaches

When trading a spot account, understand the three different types of spot account violations you may encounter: free ride violation, good faith violation, and liquidation violation.

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Key points to remember

  • Trading without fully settled cash in a no-margin account may violate Federal Reserve Regulation T.
  • Know the Three Most Common Cash Account Transaction Violations
  • Margin accounts can help avoid cash trading mistakes

Many new investors begin by using cash in a brokerage account; after all, it’s the easiest way to get started. Trading with silver sounds simple enough, but there are rules about using silver that all investors must follow, whether beginners or seasoned veterans.

The rules relate to stock settlement times and ensure that you have settled the cash in your cash account to pay for purchases. Different trading products may have different settlement times, but the standard for stocks is trade date plus two days, referred to as T+2.

Automated Clearing House (ACH) cash transfers (i.e. electronic transfers from one bank to another) can also take two to three days to fully fund. Knowing these settlement deadlines is essential to avoid breaches. Otherwise, your trading account could be subject to temporary restrictions, explained Brandon Herman, senior manager, margin clearing at TD Ameritrade.

Let’s look at the three types of cash trading account breaches and how they might occur.

Free ride

A free ride violation occurs when you arrange to put money into your trading account and immediately buy securities, but for some reason the funds do not arrive. The most common cause of freeriding is when someone tries to transfer funds, but there is a problem at the bank and the money is returned, Herman explained.

Free riding violates the Federal Reserve Board’s Regulation T regarding broker credit to clients. How can this happen? Assume that:

  • On Friday, Joe deposits $10,000 into a brokerage account.
  • On Monday, Joe places a trade for XYZ with that $10,000 without waiting for the funds to clear.
  • On Tuesday, the $10,000 returned to Joe’s bank, meaning he never paid for the original trade.
  • On Wednesday, Joe sells XYZ at a profit despite never having paid for the initial trade.

The rules on free ride violations are strict, Herman explained. If this happens only once in a 12 month period, a customer will be limited to using settled cash to transact for 90 days. The profits of the transaction can be seized and any losses incurred by the transactions are borne by the client.

Breach of good faith

Breaches of good faith occur when customers buy and sell securities before paying in full for initial purchases with settled funds. Only cash or the proceeds of a sale are considered settled funds. Here is an example of a breach of good faith:

  • On Monday, Janet holds $10,000 of XYZ.
  • On Tuesday, Janet sells her entire XYZ position for $10,500, which will settle on Thursday.
  • On Wednesday morning, Janet buys $10,500 from FAHN in good faith that the XYZ sell will settle.
  • On Wednesday afternoon, Janet sells FAHN for $11,000, making a profit of $500. However, the initial purchase of FAHN was not fully paid for as the sale of XYZ was not yet settled.

Herman noted that if this happens three times in a 12 month period, a client will be limited to trading with settled cash for 90 days.

Liquidation to respond to a call for funds

A third way for traders to violate cash trading requirements is to liquidate a position to meet a cash call. This occurs when there is not enough settled cash in a brokerage account to cover purchases on a settlement date. Herman explained how this breach occurs:

  • On Monday, Pat deposits $10,000 into a brokerage account.
  • On Tuesday, Pat buys $10,000 worth of XYZ stock. Later that day, the deposit bounces back and is returned to the bank.
  • On Wednesday morning, TD Ameritrade contacts Pat asking for money to pay for the purchase of XYZ.
  • On Wednesday afternoon, Pat sells FAHN stock for $10,500 to pay for the purchase of XYZ and meet the cash call. However, Pat’s buy of XYZ settles on Thursday and FAHN’s sell settles on Friday, so the buy remains unpaid.

If this happens three times in a rolling 12 month period, Herman said a client will be limited to trading with settled cash for 90 days.

A solution to help avoid cash account breaches

There is a way to reduce the likelihood of a breach like any of the above scenarios, Herman explained, and that is to have a margin account to help cover any shortfall.

Most people assume that margin accounts are for borrowing money to take large positions because margin accounts allow traders to fund up to 50% of their security purchases.

That’s true, but as Herman pointed out, that’s just one way of looking at 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 breach.

“In a cash account, if you buy and sell, you have to wait for that sale to settle before you can use the funds again. Some clients may find it useful to use a margin account from time to time so they can 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 the risk of loss and includes the possibility of a hard sell if account capital falls below required levels. Margin is not available in all account types. Margin trading privileges are subject to review and approval by TD Ameritrade. Carefully examine the Margin Manual 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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