Free riding

Free riding (also known as freeriding or free-riding) is a term used in to describe the practice of buying and selling shares or other securities without actually having the capital to cover the trade. In a cash account, a free riding violation occurs when the investor sells a stock that was purchased with unsettled funds.

The Federal Reserve Board's Regulation T requires brokers to "freeze" accounts that commit freeriding violations for 90 days. Accounts with this restriction can still trade but cannot purchase stocks with unsettled sale proceeds (stocks take three days to settle).

Freeriding can be avoided by using a margin account.

In the United States, stocks take three business days to settle. If you buy on Monday, you don't pay for the purchase until Thursday. This is known as trade day plus 3 days or T+3.

This three day settlement period is considered an extension of credit from the broker to the customer. Because the transaction is considered a credit issue, the Federal Reserve Board is responsible for the rule which is officially called Regulation T.

If a brokerage customer is approved for margin on the account there will be a line of credit to "cushion" the three day settlement period. This credit allows customers to trade while the cash settles. For accounts without margin (cash accounts), stock traders must have enough cash in the account to pay for any purchases the day they are due. A client in good faith agrees to make full payment of settled funds or deposit securities within the three day settlement period and not to sell before making such payment.

The Securities and Exchange Commission states "In a cash account, you must pay for the purchase of a stock before you can sell it. If you buy and sell a stock before paying for it, you are free riding, which violates the credit extension provisions of the Federal Reserve Board. If you free ride, your broker must freeze your account for 90 days."

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Wikipedia