The average day trader makes five trades per day. Most of these trades are of substantial value and can occur in between an hour or two. And since free-riding penalties occur when a stock is sold before being paid for, one may wonder how high-frequency traders avoid getting flagged for free-riding.
Day traders avoid free-riding by paying for their stock purchases using a margin account that allows them to borrow money for such investments. Therefore, despite not paying for stocks with cash, the trader takes a fair risk by leveraging himself.
In this article, you will learn in detail what free riding is, why it is penalized, and what margin accounts are. You will also discover whether margin accounts are better than cash accounts and which one you should use to trade.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Is Free Riding in Stock Trading?
In the world of trading, you earn rewards for the risks you take. Therefore, trying to make trades without any risk is like taking a free ride. That is where the term free-riding comes from.
A trader who purchases a security and sells it before paying for the security in full is free-riding and may have his account restricted. But, you might be wondering how is this even possible?
In essence, following a transaction, different financial instruments have different settlement dates. For example, a mutual fund or options trade that you make will take 1 day to settle, whereas it will take 3 days for settlement to occur for your stock and ETF trades. Hence, technically you can buy a security and sell it for profit before the settlement date, and use the proceeds or profits from this trade to cover the original purchase on the settlement date. This is how free riding becomes feasible in the world of investments and capital markets.
Free riding is not just frowned upon in the investment world, but is in fact illegal and prohibited by the S and the Securities & Exchange Commission (SEC) and the National Association of Securities Dealers. After such a restriction is placed, the trader can purchase stocks; however, sales are limited, and upon meeting settlement conditions.
Needless to say, that for a trader to have his account restricted in such a manner as to be out of day-trading for good as he’s unable to buy any stock that he cannot hold for at least two days.
How to Avoid Free Riding Violations?
When you see how serious the consequences of a free-riding violation are, you may wonder if there is a way to avoid this penalty without being cash-heavy. To avoid free-riding violations, you must make sure that any stock you sell is paid for in full. As long as you stop assuming that your ability to sell a stock equals permission to do so, you’ll be safe.
Mostly, it is the novice or the uninformed hobbyist who find themselves in violation of free-riding restrictions. That is because the traders may assume that just because they can sell a stock means they have the right to. Unfortunately, that isn’t the case, and unless the trader has paid for the stock, it is not safe to sell.
Why Is Free Riding Restricted?
Free riding restrictions prevent many traders from multiplying their trading figures. One would assume that reducing trade is bad for the stock exchange. If free riding can encourage trading, why is it restricted?
Free riding is prohibited because it can create a false-market-price based only on risk-averse trading choices. For instance, if a stock has an apparent bull run, a trader may ‘buy’ the stock without paying for it and sell it in a few hours to pocket the difference and pay for the initial ‘purchase’. But because the trader hasn’t invested anything and had no skin in the trade, his purchase doesn’t reflect a trader’s decision regarding the value of the stock.
If millions of traders start buying stocks without paying for them only with the intention to sell at a higher point, the stock exchange would resemble a Ponzi scheme instead of a system for determining the market value. Therefore, every trade must involve the sale of stocks that are fully paid for.
How Can You Day Trade Without Having a Lot of Cash?
As we have established earlier, you can only sell stocks you have fully paid for. This obviously restricts you to trading with only the cash you have available. But often, you might find an opportunity for trade only to realize you don’t have the money for it. How can you make a trade in such a case without getting flagged for a free-riding violation?
The answer is simple: borrow money. If you believe a stock is worth $50 because it will be worth more later, you should not have a problem borrowing fifty dollars to pay for it as you would make more (according to your assessment) in the future.
By doing this, you are making yourself financially liable for your trading decision, and your trade is based on financial reasoning rather than an opinion without risk. That is fair for the market, and the reward you reap is based on real risk. But doesn’t taking loans require a longer processing time? Enter Margin accounts.
What Is a Margin Account?
To put it simply, a margin account is like a credit card for your stock trades. You get to borrow the money you don’t have in hand to participate in a trade. When you “buy” a stock, you are paying for it in full by taking debt. This way, if the stock goes down, you have financial liability, and if it goes up and you sell, you can make money without the impact being felt by your cash account.
What Is Better? Trading With Cash or Margin?
As with any two options presented as methods to the same goal, one asks which is better. In the case of buying a stock with complete rights to sell, you can use your cash account or a margin account. But which is the right option for you depends on who you are.
Most long-term investors rely on cash because there is no logical reason to hold a stock with debt. But day-traders almost exclusively use margin accounts because they want gains of some trades to offset the losses of others. That isn’t possible with cash as the cash that’s gone is gone while the borrowed money that is gone can be paid-back by making more money off of other trades made via margin.
Pros of Cash Accounts
Here are some of the advantages you have for trading with cash:
- Realistic risk appetite – When you trade with only the money you have, you avoid the gamblers’ fallacy and keep yourself from going deeper into debt just to pay off other debt.
- You don’t pay interest – When you trade with your own money, you may have more immediate risk, but you also avoid interest that can compound and keep you from ever trading freely again (if decisions are bad enough).
- The best way to test the waters – When you trade for the first time, it is ideal to use your own money so you can learn without your mistakes costing you exponentially. While margin accounts allow you to scale your rewards, they do so with expansive risk.
Cons of Cash Accounts
By trading with your cash account, you may shoulder the following burdens:
- Limited trading ability – Since all trade involves inherent risk, to get in the game only to play risk-averse isn’t a winning attitude. You cannot trade on an opportunity when you’re restricted by the cash you have.
- Restricted from rewards – When you trade with cash, you may be free of leverage, but there is an upper limit to the rewards you can reap.
Pros of Margin Accounts
Trading with margin accounts will give you the following benefits:
- Ability to scale your returns – People often say that a hundred thousand dollars in Facebook would be worth a billion now. With the right margin account, you would only need $1000 to make that investment.
- You can correct your mistakes – Losses in cash are irreversible, whereas any loss you take with a trade made via margin can be paid for with a better trade may also via margin. Most of the time, your cash account doesn’t see the negative impact as long as you make enough positive returns before the settlement period.
Cons of Margin Accounts
There is only one main disadvantage of a margin account:
- Interest – You have to pay interest if you do not make enough money to pay back the amount you’ve borrowed. While this seems like a disadvantage, it is also the necessary condition to keep you from taking unnecessary risks beyond your risk appetite.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
- Roadmap to Becoming a Consistently Profitable Trader: I surveyed 5000+ traders (and interviewed 50+ profitable traders) to create the best possible step by step trading guide for you. Read my article: ‘7 Proven Steps To Profitable Trading’ to learn about my findings from surveying 5000+ traders, and to learn how these learnings can be leveraged to your advantage.
- Best Broker For Trading Success: I reviewed 15+ brokers and discussed my findings with 50+ consistently profitable traders. Post all that assessment, the best all round broker that our collective minds picked was M1 Finance. If you are looking to open a brokerage account, choose M1 Finance. You just cannot go wrong with it! Click Here To Sign Up for M1 Finance Today!
- Best Trading Courses You Can Take For Free (or at extremely low cost): I reviewed 30+ trading courses to recommend you the best resource, and found Trading Strategies in Emerging Markets Specialization on Coursera to beat every other course on the market. Plus, if you complete this course within 7 days, it will cost you nothing and will be absolutely free! Click Here To Sign Up Today! (If you don’t find this course valuable, you can cancel anytime within the 7 days trial period and pay nothing.)
- Best Passive Investment Platform For Exponential (Potentially) Returns: By enabling passive investments into a Bitcoin ETF, Acorns gives you the best opportunity to make exponential returns on your passive investments. Plus, Acorns is currently offering a $15 bonus for simply singing up to their platform – so that is one opportunity you don’t want to miss! (assuming you are interested in this platform). Click Here To Get $15 Bonus By Signing Up For Acorns Today! (It will take you less than 5 mins to sign up, and it is totally worth it.)
Conclusion
Day traders make frequent trades and would require a lot of money to fund their transactions to avoid free-riding if not for margin accounts. With a margin account, traders can borrow the money to buy the stocks they wish to sell in the short-term. Often, before the settlement date, traders have made a net-profit before their cash accounts get affected.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
Affiliate Disclosure: We participate in several affiliate programs and may be compensated if you make a purchase using our referral link, at no additional cost to you. You can, however, trust the integrity of our recommendation. Affiliate programs exist even for products that we are not recommending. We only choose to recommend you the products that we actually believe in.
Recent Posts
Exploring Social Trading: Community, Profit, and Collaboration
Have you ever wondered about the potential of social trading? Well, that curiosity led me on a fascinating journey of surveying over 1500 traders. The aim? To understand if being part of a trading...
Ah, wine investment! A tantalizing topic that piques the curiosity of many. A complex, yet alluring world where passions and profits intertwine. But, is it a good idea? In this article, we'll uncork...