Avoiding cash account trading violations: settled cash, freeriding and good faith rules
Editorial staff, J.P. Morgan Wealth Management
- When you use a cash account to trade securities, be careful not to violate cash trading rules.
- If you violate the rules three times in a 12-month period, your account can be restricted or closed.
- To avoid violations, make sure you have enough settled cash in your account to cover purchases.
For investors, cash trading can offer a less complex entry point than margin trading. But trading in cash comes with unique rules that can catch traders off guard – particularly when it comes to potential violations.
Violating the rules for cash trading can lead to account restrictions, freezes and even closures.
In this article, we’ll explain what cash trading is, the key types of cash trading violations, the penalties associated with them and – most importantly – how to avoid making these costly mistakes.
What is cash trading?
Cash trading means using a brokerage account to buy securities without borrowing, with the expectation that you’ll make full cash payment for any purchases. This is different from margin trading, where you can borrow from your broker-dealer to buy securities.
Investors may choose cash trading for a number of reasons, including when they are newer to investing or want to avoid the complexities of margin trading.
What are the rules of cash trading?
Understanding the rules that govern cash trading is the best way to avoid violations. A key set of rules comes from the Federal Reserve Board’s Regulation T (“Reg T”), which governs how broker-dealers extend credit and includes requirements that affect cash accounts.
In cash trading, it’s critical that all trades settle. The settlement cycle is the trade date (T) plus the number of business days it takes for cash and securities to be officially exchanged.
In 2024, the standard settlement cycle moved to T+1 (one business day after the trade date). Before that, it was T+2, and earlier, in the 1990s, it was T+3.
Who sets the rules for cash trading?
Cash account trading rules are set by the SEC and the Financial Industry Regulatory Authority (FINRA), which regulates broker-dealers to help maintain market integrity and protect investors. Your brokerage may also apply additional rules and restrictions.
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What are the most common cash trading violations?
The most common cash account trading violations fall into three categories, each involving the trading of securities for which funds have not yet fully settled.
Good faith violations
A good faith violation can occur when you buy a security using proceeds from a sale that haven’t settled yet, then sell the security before the original sale settles (or before you add cash to fully pay for the purchase). To be considered settled funds, the trade or deposit must be completed and the funds fully transferred to your trading account.
Let’s consider an example: On Day 1, you sell 10 shares of Stock A. Also on Day 1, you purchase 10 shares of Stock B. Subsequently, on Day 2, you sell the 10 shares of Stock B. Given that the proceeds of the Stock A sale hadn’t been settled to fund the Stock B purchase, and you sold Stock B before the cash to make the purchase had settled, this sale would be considered a good faith violation.
Freeriding violations
Freeriding refers to buying a security in a cash account and then selling it before paying for the purchase. This is a violation of Reg T.
For example, suppose an investor buys shares of a stock on Monday but doesn't have the funds to pay for them. On Tuesday, the investor sells the same shares before the payment for the purchase is due. The investor uses the proceeds from the sale to pay for the initial purchase. This is considered freeriding because the investor is essentially using the brokerage's money to finance the purchase without having the funds upfront.
Liquidation violations
A liquidation violation can occur when you buy securities without sufficient settled funds, then sell other securities to cover the purchase.
For example, let’s say you have $1,000 in your account.
- On Day 1, you place an order to buy 100 shares of Stock A when it’s trading around $9.90, so you expect to have enough money to cover the trade at that price.
- On Day 2, Stock A’s share price rises and your order is executed at $10.10 per share.
- On Day 3, you see the negative balance and sell another holding to cover the purchase of Stock A.
What happens if you violate cash trading rules?
Brokerages track cash trading violations, and regulators require broker-dealers to maintain records of activity. If you have three violations in a 12-month period, your account may be placed on a 90-day “settled-cash-only” (or “funds-on-hand”) restriction. This means you’ll have to fully pay for all purchases in settled cash on the date of the order. In other words, you’ll need sufficient cash in your account before you can buy anything.
If you rack up too many violations, your brokerage may even restrict you from making any trades and close out your account. To get your account reinstated, you can wait out the restriction period; contact your broker to request a typically one-time reinstatement (not guaranteed); or move to another broker, knowing that violation history may be reviewed.
You can also switch to a margin account, though you’ll likely need to maintain a minimum balance. If you day trade in a margin account, you may become subject to pattern day trader requirements. A margin account can help avoid settlement timing issues but involves more complex rules and greater account scrutiny. It’s important to note that pattern day trader rules apply specifically to margin accounts, not cash accounts.
How to avoid cash trading violations when trading frequently
Cash trading violations may be less of a problem for investors employing a buy-and-hold investment strategy and more of a concern for those trading more frequently. It’s important to note that cash violations can occur even if you are not day trading, as day trading is a specific form of trading activity. If you’re concerned about violating cash trading rules, keep the following things in mind:
Track settled cash
Use only funds that have fully settled when possible. You may be able to buy with proceeds from a sale that hasn’t settled yet, but avoid selling the new purchase until the original sale settles (or until you’ve added cash to fully pay for it). Monitoring your brokerage account can help with this, as it will likely show “settled cash” separately from your total cash balance.
Keep a trade log
If you’re placing multiple trades a day, especially on volatile days, keep a simple spreadsheet or note that details what you’ve bought, when funds settle and what you plan to buy or sell next. A bit of organization can help you avoid overlapping unsettled transactions.
Consider a margin account
If you’re trading frequently, consider switching to a margin account, which may help you avoid making cash trading violations. While a margin account may make sense for your investment strategy, keep in mind that margin trading comes with additional risk. It also may require a minimum account balance as well as a thorough understanding of margin calls and pattern day trader requirements.
The bottom line
While cash accounts can be a good entry point for traders looking to avoid risk, they come with their own set of rules – particularly around the use of settled funds. Violations like freeriding and good faith violations can restrict your trading abilities and derail your strategy.
Frequently asked questions about cash trading violations
You may be able to place trades using unsettled proceeds, but selling a purchase before you’ve made full cash payment can trigger a cash account violation. To avoid violations, pay close attention to settlement timing and your broker’s “settled cash” and “available to trade” balances.
No, there are no set limits to how often you can trade with a cash account, provided you’re not violating cash trading rules. You must use settled funds to pay for each trade and make sure the money is already in your account. Keep in mind that frequent trading can also have tax implications, such as triggering wash sale rules or affecting your tax reporting.
Cash accounts can be an effective approach for investors who prefer a more straightforward trading experience. The limiting nature of this account type can keep an investor from taking on advanced techniques – such as using margin debt or short selling – before they’re ready. That said, individual investment choices and asset selection still ultimately contribute to risk. It’s important to understand the implications of cash accounts and their potential limitations.
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