Buying and selling stocks can be a profitable way to invest money. While buy-and-hold investing gets all the mainstream press, money-making trades can be made in the shorter term as well. However, certain types of trades are restricted or prohibited depending on how the trades are made, and the type of account from which the trade is made. Free-riding is one type of trading that is prohibited for all types of investors.
Free-riding, or free-ride trading, is a type of trade that occurs when an investor purchases stock, then sells that stock for a profit without having enough cash in the account to cover the initial stock purchase.
Stock trades take three days to settle. That is, when an order is entered, while the stock is purchased or sold immediately, the shares and the money associated with that trade actually move between institutions or accounts three days after the trade. Theoretically, a trader could purchase stock with zero dollars in his account and as long as the money was there three days later, the trade could still properly settle.
A trader with zero dollars in his account could, hypothetically, purchase $50,000 worth of stock, then turn around and sell that stock later that day for $55,000. The $55,000 from the sell could be used to pay the $50,000 three days later during settlement. This is known as freeriding because it would allow the investor to trade for free.
Free-riding is prohibited under Regulation T, the rules and procedures governing various banking and investing account activities. Regulation T is published and enforced by the Federal Reserve as part of its oversight of the financial system.
One of the often-cited causes of the stock market crash of 1929 was the over extension of credit to stock traders. Prior to the crash, many traders had huge stock positions, many of them purchased with credit or on the margin. When stock prices fell rapidly, these traders could not sell their stock for enough money to pay back their loans. Whereas a profitable free-ride trade would allow the investor to profit, an unprofitable trade could leave the trader unable to cover his losses. Thus, free-riding done on a large scale could cause significant financial problems for several institutions.
Regulation T's prohibition on free-riding is one of the restrictions to help prevent a similar scenario from happening again.
In a cash-account (non-margin account), a customer is required to make full cash payment for securities before selling them. Thus, a trader cannot sell the same securities bought to pay for their purchase. If a free-riding trade occurs within a cash account, the account will be frozen for 90 days.
In a margin account, the amount of credit normally available to the trader based on the holdings in the account must be sufficient to cover the cost of the original purchase in full. If the trader does not have sufficient collateral to make the original purchase at the time of the purchase, then the trade will be considered free-riding and the account will be frozen for 90 days.
A margin account is a brokerage account in which the investor has a line of credit that is collateralized by the investor's holdings within the account. While this credit is subject to different regulations, it can prevent a violation of free-riding provisions. For example, an investor with a margin account could purchase $50,000 worth of stock and sell it for $55,000 later that day. Even if there is no cash in the account, as long as the customer would normally be entitled to a margin loan equal to the original purchase price ($50,000), then the trade would not be considered a free ride. Rather, such a trade would be considered the extension of credit by the brokerage, and the subsequent repayment of that credit. Whether or not the brokerage firm would charge any interest on a same-day margin loan is up to the policies of the firm.