Avoiding cash trading violations
Editorial staff, J.P. Morgan Wealth Management
- When you use a brokerage account to trade securities, you must be careful not to violate the rules of cash trading.
- If you violate the rules three times in a year, your account can be restricted or closed.
- To avoid violations, make sure you have enough cash in your account so you can cover your securities purchases.
For investors, cash trading can offer lower-risk market entry 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 trade securities with the condition that the investor must pay the full amount when buying and selling. This is different from margin trading, where buyers and sellers trade stock on credit.
Traders engage in 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. Collectively, these rules are known as Regulation T – “Reg T” – and they also cover margin trading.
In cash trading, it’s critical that all trades get settled or finalized. The settlement cycle consists of a trade date, T, plus the number of business days required for the funds to settle.
May 2024 saw the introduction of the T + 1 settlement cycle, which was an answer to the need for faster transactions driven by an ever-increasing reliance on technology in trading. Prior to 2024, the settlement cycle was T + 2, and further back, in the ‘90s, it was T + 3. The time progressively shortened over the decades as tech improved.
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Who sets the rules for cash trading?
Cash trading rules are set by the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), an organization that regulates broker-dealers in an effort to maintain market integrity and protect investors. Your brokerage may also set its own rules and restrictions in addition to those set by the SEC and FINRA.
What are the most common cash trading violations?
The most common cash 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 occurs when you purchase a security with cash that hasn’t settled, then sell the security before the proceeds to cover the purchase have settled. 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 securities using a cash account, then selling them before the purchase has settled. When traders do this, they’re using money from the proceeds of the sale instead of using cash, which is a violation of Regulation 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 happens when you buy securities on one day, then sell securities the next day to cover the initial purchase.
For example, let’s say you have $1,000 in your account. On Day 1 at 6 p.m., you enter an order to buy 100 shares of Stock A. The stock closed at $9.90, so you have enough money to cover the trade, based on that day’s 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 something to cover the purchase of Stock A.
What happens if you violate cash-trading rules?
Your brokerage, the SEC and FINRA all track stock market trades. If you have three violations in a 12-month period, your account will be put 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 violations; contact your broker requesting what’s typically an unguaranteed, one-time reinstatement; or move to another broker, knowing that records of violations can be checked.
You can also switch to a margin account, though you’ll likely need to make a deposit of a certain amount and get approved as a pattern day trader. This 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 good faith violations when day trading
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. If you sell a security one day, don’t use the proceeds from the sale to buy another security until the next business day. 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 detailing what securities you’ve bought, when they’ve settled 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 rules.
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 breaches can restrict your trading abilities and derail your strategy.
Frequently asked questions about cash-trading violations
While you may be able to trade with unsettled cash, this is considered a cash trading violation. Your trades must settle before you can use the funds to make other trades or purchases. If you don’t, you’ll be in violation of at least one of the cash trading rules.
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 for the trade is already in your account and not borrowed from somewhere else. 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 – e.g., leveraging margin debt or short selling – before they’re ready. That said, individual investment choices and asset selection still ultimately contribute toward risk. It’s important to understand the implications of cash accounts and their potential limitations.
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Editorial staff, J.P. Morgan Wealth Management
