Understanding cash substitution and freeride violations for cash accounts

E*TRADE Securities2

10/18/17

When using cash accounts, there are rules and requirements you should be aware of. One rule is that customer purchases must be fully paid for on or before the settlement date. Two others include cash substitution violations and freeride violations.

 

What is a cash substitution violation?

 

A cash substitution violation, also known as a good faith violation, is issued when a position is opened using unsettled funds and the position is closed before the funds used to make the opening trade have settled. Settlement on a stock trade is the trade date plus two business days (T+2), whereas the settlement on an options trade is the trade date plus one business day (T+1).

A cash substitution violation remains on an account for a 12-month rolling period. When an account is issued its fourth cash substitution violation within a 12-month rolling period, the account is restricted to cash-only, settled-cash status for 90 days from the due date of the fourth cash substitution violation.

Here’s an example of how a cash substitution violation works:

On Monday, February 2, a customer sells 100 settled shares of XYZ, which generates proceeds of $5,000. This trade will settle on T+2, which is Wednesday, February 4. He uses the funds to purchase shares of ZZZ.

On Tuesday, February 3, the customer sells the shares of ZZZ. The customer will be issued a cash substitution violation because he did not hold the purchase made with the proceeds from selling XYZ for two business days (at which time the XYZ stock would have settled).

 

What is a freeride violation?

 

A freeride violation is issued when a position is opened without sufficient funds and the position is liquidated before funds are deposited into the account. When the violating position is liquidated to satisfy a cash call, a freeride violation and liquidation strike are issued. If a position other than the violating position is liquidated to pay for the first trade, a freeride violation is not issued but a liquidation strike is issued. Freeride violations can only be met by depositing funds into the account in the amount of the call by T+4.

When an account is issued its first freeride violation, the account is considered restricted for 90 days from the due date of the violation. After 90 days, the freeride violation expires.

It is important to be aware that Automated Clearing House (ACH) and check deposits do not meet freeride violations until the broker-dealer has reviewed the process by which a deposit is made. ACH and check deposits typically become available for trading on the third business day after having been received.

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