Suppose you have $0 balance in a cash account. You buy ABC for $1000, and sell it for $1050 on the same day. Is it a free riding violation?
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5Why would the brokerage allow you to buy stock if you don't have the money?– jamesqfCommented Aug 18, 2019 at 16:06
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When shit hits the fans, brokers need people to fulfil the contract. Zero balance is a no go for most of the retail investor. However, if a broker allows you to do it, it is their problem if you refuse to pay.– mootmootCommented Aug 19, 2019 at 12:05
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3 Answers
Yes, as the SEC explains, Federal Reserve Board's Reg T requires that you pay for the purchase of a security before you sell it:
In a cash account, an investor must pay for the purchase of a security before selling it. If an investor buys and sells a security before paying for it, the investor is “freeriding” which is not permitted under the Federal Reserve Board’s Regulation T and may require the investor’s broker to “freeze” the investor’s cash account for 90 days.
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Suppose that after buying and selling as in the question, the investor deposits $1000 (the purchase price) with the broker the next day (before the purchase settles). Then would he be okay (not in violation)? This question is based on the first paragraph of @farnsy’s answer, which says that the actual violation is using the unsettled funds from the sale to settle the purchase. Of course your quote contradicts that, but I wonder if it is a simplification of the actual regulation.– prlCommented Aug 19, 2019 at 6:48
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2@prl From all I've read, it's not about paying prior to settlement, but prior to selling. Using unsettled funds to purchase would be a good faith violation which carries a lesser punishment than free riding violations.– Hart COCommented Aug 19, 2019 at 14:08
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Any feedback to accompany downvote? Would love to make the answer better if you feel it is lacking.– Hart COCommented Aug 19, 2019 at 17:27
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Bear in mind that, OP question can be irrelevant according to individual brokers policies and regulation. That means OP can't even initial the purchase in the first place. Please edit your question to point out the logic issue.– mootmootCommented Aug 20, 2019 at 7:47
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@mootmoot Very true, at the minimum you can expect that they follow federal and state regulations, and certainly they'll have devices other policies to protect themselves as needed.– Hart COCommented Aug 20, 2019 at 13:45
Free riding in general means buying without having the money to do so (generally, using unsettled funds from its own sale to cover the cost). At the retail level, your broker will generally have rules that prevents free riding in your account. Your broker is incentivized because the fundamental problem is that you effectively borrowed money without actually borrowing it and paying interest on it.
In a cash account, what you describe is kind of the classic case of free riding. You didn't have any money in your account to make the purchase. Instead you paid for it with the revenue from its own sale and your broker would have been on the hook if the price had fallen.
In a margin account, which many brokerage accounts are, the definition is a little more foggy because every transaction is paid for with borrowed funds. In this case your broker will let you know what type of transactions are prohibited (and it will vary by broker).
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Fogginess? Not really. Free riding does not apply to margin accounts. Every transaction in a margin account is NOT paid for with borrowed funds. You borrow when you run out of cash IF you choose to go on margin. A margin account offers a line of credit that avoids two day settlement, allowing one to continue to trade while the transaction settles. If you have the margin requirement, the broker will execute the trade. A broker might not offer a type of trading (say futures) but they don't prohibit transactions. What they can do is require a higher margin requirement than Reg T. Commented Aug 18, 2019 at 15:22
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For example, my broker used to not let me buy and sell and buy again in my margin account in the same day and they called it 'free riding'. The SEC's definitions were not relevant, only my broker's, which is why it was foggy. If, indeed, only the SEC's explicit definition is used then there is no free riding in margin accounts, but I'm fairly clear in mentioning that it's the brokers that are the impediment there. Though if your trading pattern effectively exceeds your margin capacity without technically doing so, you may still be pursued by the SEC for the same type of violation.– farnsyCommented Aug 18, 2019 at 15:26
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@ farnsy - SEC and FINRA definitions are relevant because they set initial margin as well as minmum margin maintenance requirement. Brokers have the right to require more and they also have the right to deny you the opportunity to trade anything they consider too risky for their taste. Exceeding " your margin capacity without technically doing so" ? If by that you mean have less than 50% margin for your buys, that's a margin violation not free riding - and not the same type of violation. Commented Aug 22, 2019 at 23:24
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@BobBaerker My point was that one's broker may use the language "free riding" even if it is not such as narrowly defined by investopedia and perhaps by regulators. However, as one could interpret the OP as a request for a definition, I'm glad you chimed in.– farnsyCommented Aug 23, 2019 at 3:38
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A broker calling a margin violation free riding is like me calling an apple an orange and claiming that I'm right because they're both fruit. Regulatory agencies make the legal rules. Brokers can explain them any way they want, but the rules have to be followed as written. Commented Aug 23, 2019 at 12:28
Nope. It is called day trading.
THAT SAID - you will not be able to execute the buy with 0 balance. This is quite standard for many day trade operations where "0 balance" means "no profits for the day on YOUR account" not "no money at the broker" (as the broker accounts are owned by the company).
Otherwise no broker will let you buy stock with 0 balance - you lack the funds for fees and have no collateral against the margin you need to execute the buy.
