What Happens If You Sell Before Cash Settles: Understanding Cash Account Trading Violations

Have you ever been in a situation where you wanted to quickly buy and sell stocks but weren’t sure about the rules? I recently found myself wondering what would happen if I sold securities before my cash settled in my trading account. Let’s dive into this topic and understand the potential consequences

The Basics of Cash Account Trading

Before placing your first trade, you need to decide whether you’ll trade on a cash basis or on margin. In a cash account you must pay for all purchases in full by the settlement date.

For example, if I bought 1,000 shares of ABC stock on Monday for $10,000, I would need to have $10,000 in cash available in my account to pay for the trade by the settlement date. According to industry standards, most securities have a settlement date that occurs on trade date plus 1 business day (T+1). So if I buy a stock on Monday, the settlement date would be Tuesday.

Trading strictly on a cash basis seems simple, but there are three types of potential violations you should avoid

• Good faith violations
• Freeriding violations
• Cash liquidation violations

Let’s break these down so you don’t accidentally get your account restricted.

Good Faith Violations: Selling Before Your Cash Settles

What Is a Good Faith Violation?

A good faith violation happens when you buy a security and sell it before paying for the initial purchase in full with settled funds. Only cash or the sales proceeds of fully paid securities qualify as “settled funds.”

When you liquidate a position before it was ever paid for with settled funds, it’s considered a “good faith violation” because you didn’t make a good faith effort to deposit additional cash into the account before the settlement date.

Examples of Good Faith Violations

Example 1: Marty’s Mistake

• Cash available to trade = $0.00
• Monday morning: Marty sells XYZ stock and nets $10,000 in cash account proceeds
• Monday afternoon: He buys ABC stock for $10,000
• If Marty sells ABC stock before Tuesday (the settlement date of the XYZ sale), this would be a good faith violation because ABC stock was sold before the account had sufficient funds to fully pay for the purchase.

Example 2: Trudy’s Trades

• Cash available to trade = $10,000 (all settled)
• Monday morning: Trudy buys $10,000 of XYZ stock
• Monday mid-day: She sells XYZ stock for $10,500

At this point, Trudy hasn’t incurred a violation because she had sufficient settled funds to pay for the XYZ purchase. However:

• Late Monday: Trudy buys $10,500 of ABC stock
• Monday afternoon: She sells ABC stock and incurs a good faith violation

This is a violation because Trudy sold ABC before Monday’s sale of XYZ stock settled, and those proceeds weren’t yet available to pay for the ABC stock.

Consequences

If you get three good faith violations in a 12-month period in a cash account, your brokerage will restrict your account. This means you’ll only be able to buy securities if you have sufficient settled cash in the account PRIOR to placing a trade. This restriction will be effective for 90 calendar days.

Trust me, you don’t want this hassle!

Freeriding Violations: The Big No-No

What Is a Freeriding Violation?

While “freeriding” sounds fun, it’s actually a serious violation. Freeriding occurs when you buy securities and then pay for that purchase using the proceeds from a sale of the SAME securities. This practice violates Regulation T of the Federal Reserve Board concerning broker-dealer credit to customers.

Examples of Freeriding

Example 1: Marty’s Money Problems

• Marty has $0 cash available to trade
• Monday morning: Marty buys $10,000 of ABC stock
• No payment is received by Tuesday’s settlement date
• Wednesday: Marty sells ABC stock for $10,500 to cover his purchase cost

This is a freeriding violation because Marty didn’t pay for the stock in full before selling it.

Example 2: Trudy’s Takeover Opportunity

• Trudy has $5,000 cash available to trade
• Monday morning: She buys $10,000 of ABC stock with the intention of sending a $5,000 payment through electronic funds transfer before Tuesday
• Later Monday: ABC stock rises dramatically due to takeover rumors
• Tuesday: Trudy sells ABC stock for $15,000 and decides not to send the $5,000 payment

A freeriding violation occurs because the $10,000 purchase was paid for, in part, with proceeds from the sale of ABC stock itself.

Consequences

If you incur just ONE freeriding violation in a 12-month period in a cash account, your brokerage firm will restrict your account. This means you’ll only be able to buy securities if you have sufficient settled cash in the account prior to placing a trade. The restriction lasts for 90 calendar days.

Freeriding is taken very seriously by brokerages – one strike and you’re restricted!

Cash Liquidation Violations: Another Way to Get in Trouble

What Is a Cash Liquidation Violation?

A cash liquidation violation happens when you buy securities and cover the cost by selling other fully paid securities AFTER the purchase date. This violates brokerage industry rules that require you to have sufficient settled cash in your account to cover purchases on settlement date.

Example of a Cash Liquidation Violation

Marty’s Mistake:

• Cash available to trade = $0.00
• Monday: Marty buys $10,000 of ABC stock
• Tuesday: He sells $12,500 of XYZ stock to raise cash for the ABC trade (settling Tuesday)

A cash liquidation violation occurs because when ABC purchase settles on Tuesday, Marty’s account won’t have sufficient settled cash to pay for it. The sale of XYZ won’t settle until Wednesday.

Consequences

If you get three cash liquidation violations in a 12-month period in a cash account, your brokerage firm will restrict your account. You’ll only be able to buy securities if you have sufficient settled cash in the account prior to placing a trade, with the restriction lasting 90 calendar days.

How to Avoid These Trading Violations

After learning about these violations, I realized how important it is to understand the rules before actively trading. Here are some tips to help you avoid cash account trading violations:

1. Keep track of your settled funds: Always know how much settled cash you have available for trading.

2. Understand settlement dates: Remember that most securities settle T+1 (trade date plus one business day).

3. Wait for settlement before selling: If you buy securities with unsettled funds, wait until those funds settle before selling the new securities.

4. Consider a margin account: If you’re an active trader, a margin account might be more appropriate as it allows more flexibility (though it comes with its own risks).

5. Use a trading journal: Keep track of your trades, including purchase dates, settlement dates, and fund sources.

A Personal Trading Calendar Can Help

One system that has helped me avoid violations is creating a simple trading calendar. Here’s an example of how you might set it up:

By tracking your trades like this, you can easily see when funds will settle and avoid making trades that could lead to violations.

What If You’ve Already Made a Violation?

If you’ve already made one of these violations, don’t panic! Here’s what you should do:

1. Check your account status: Most brokerages will notify you of violations and tell you how many you’ve accumulated.

2. Understand the consequence: If you’ve reached the limit, understand the restrictions placed on your account.

3. Wait it out: Unfortunately, if your account is restricted, you’ll typically need to wait out the 90-day restriction period.

4. Learn from it: Use this as a learning opportunity to better understand trading rules.

5. Consider different account types: If you’re an active trader, you might want to switch to a margin account after your restriction period ends.

My Experience with Trading Violations

I’ll admit, when I first started trading, I made a good faith violation without even realizing it. I had sold some shares of a stock and immediately used those unsettled funds to buy another stock, which I then sold the same day. I got a notification from my broker warning me about the violation.

Since then, I’ve been much more careful about tracking my settled funds and making sure I understand the rules. It’s definitely a learning process, but avoiding account restrictions is well worth the extra attention to detail.

Final Thoughts: Playing by the Rules Pays Off

Understanding what happens if you sell before cash settles is crucial for anyone trading in a cash account. The consequences—account restrictions that last 90 days—can seriously hamper your trading activities.

Remember:

• Good faith violations occur when you sell securities before paying for them with settled funds
• Freeriding violations happen when you sell securities to pay for those same securities
• Cash liquidation violations occur when you sell securities to pay for previously purchased securities

By understanding these rules and keeping track of your settled funds, you can avoid these violations and trade more effectively. It’s worth taking the time to understand these concepts now, rather than learning them the hard way through account restrictions.

Have you ever encountered any of these violations? What strategies do you use to keep track of your settled funds? I’d love to hear about your experiences in the comments!