Subject: Trading - Free Ride Rules

Last-Revised: 12 Jul 1997
Contributed-By: Karl Denninger (karl at mcs.com), Timothy M. Steff (tim at navillus.com)

When trading stocks, a "free ride" describes the case when you buy a security at 10 and sell it a day later (or an hour later) at 12, without having the free funds to cover the settlement of the trade at 10. This activity is prohibited by the exchanges (e.g., NYSE Rule 431 forbids member organizations from allowing their customers to day-trade in cash accounts). If you trade in a cash account, you must be able to settle the trade, even if you would take the profit from it in the same day.

Example:

Buy 1000 XXX at $10 on 7/10

Requires $10,000 free cash available to settle the trade.

Sell 1000 XXX at $15 on 7/11

It's a day later, and you will get $15,000 from the sale, but you still must be able to settle the original purchase without the proceeds of the sale for the first trade to be legit.

The rule on free rides should in no way be interpreted as a prohibition on "day trading" (i.e., trading very rapidly in and out of a stock). You can "day-trade" as much as you want, provided that you can settle the trade. The short answer is that you must use a margin account if you want to day-trade.

Being able to settle the trade means that you either have sufficient cash in your account to pay for the shares, or sufficient reserve in your margin account to cover the shares. Note that equity trades settle 3 market days after execution. Therefore, the window on short-term trading is not one day but rather three; i.e., any close of a position before settlement occurs would run into the same issue.

If you use cash, note that in a cash account you can spend a dollar only once. That is to say if you start the day in cash, you can buy stock and sell that stock -- and then are done trading for the day. If you start in stock you can sell it, spend the cash for another position, sell that position and then you are done.

If you use margin, keep in mind that your broker is allowed to delay the credit for your sale until settlement if they so choose, keeping you from using those funds for three days. If they are a market-making firm or are selling their order flow they will likely obstruct your intra-day and short term trading since it cuts into their bottom line. To day-trade using a margin account, you need a broker that uses NYSE day-trading rules for margin. Chances are your broker will have no idea what you are talking about if you ask about this.

Unlike stocks, options settle the next day, which is both good and bad. Option trading basically requires that the funds be there before you place the trade, unless you like wiring funds around (and paying for the privilege of doing so).

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