Good Faith vs. Freeriding: Cash Account Violations Explained
Understanding Cash Account Trading Violations
Retail investors using cash accounts face two primary trading restrictions that are often confused: good faith violations and freeriding violations. Both stem from the same core issue—trading with unsettled funds—but they differ fundamentally in intent, consequence, and regulatory standing.
What is a Good Faith Violation?
A good faith violation occurs when you purchase a security with cash that hasn't settled, then sell the security before the proceeds to cover the purchase have settled, with the investor using the proceeds from the sale to pay for the initial purchase.
For example: You sell Stock A and immediately use the proceeds to buy Stock B before your Stock A sale has settled. Most U.S. stock trades now settle on a T+1 basis — one business day after the trade date, which became the standard on May 28, 2024. If you sell Stock A on Monday and buy Stock B on Monday, then sell Stock B on Tuesday before Stock A's Tuesday settlement, you've triggered a good faith violation.
The Federal Reserve considers a good faith violation an "abuse of credit" and requires the broker keep track of them; if the trader has four good faith violations in one year, the broker is required to restrict the account. More commonly, if you receive 3 good faith violations in a 12-month period, your cash account will be restricted for 90 days, with the brokerage only allowing purchases if there's fully settled cash in your account prior to trading.
What is Freeriding?
Freeriding refers to buying securities using a cash account, then selling them before the purchase has settled. The critical difference: the main difference between a good faith violation and freeriding is the eventual deposit of funds to cover the purchase; in freeriding, the buyer sells the security without ever depositing the funds to pay for the initial purchase.
In practical terms, freeriding happens when your account has zero settled cash, you buy a security using unsettled funds or margin, and then sell it to cover the original purchase cost. Federal Reserve Board's regulation T specifically addresses the "cash account," stating that if a customer buys a security in a cash account and then sells it without having made "full cash payment" for the purchase, the account must be restricted; in plain English, Reg T says you cannot use the proceeds from a sale to pay for the original purchase.
A freeriding violation results in an automatic restriction, compared to a good faith violation which requires four violations in one year for restriction. This is why freeriding is considered the more serious offense.
The Key Distinction
The key difference between free riding and good-faith violations is the future deposit of funds to cover the initial purchase; those who freeride sell a security without depositing funds to pay for its initial purchase. In a good faith violation, you *had* sufficient buying power when you made the first trade; in freeriding, you *never had* the funds to begin with.
Practical Avoidance
To avoid both violations in a cash account: ensure you have settled cash in your accounts to cover trades and must not intentionally abuse broker-dealer regulations, such as Federal Reserve Board's Regulation T. Wait for all trades to settle (T+1) and all deposits to clear before redeploying those proceeds into new trades.
Understanding the settlement timeline—especially the T+1 rule introduced in May 2024—is essential. Good faith violations are often accidental and happen when investors assume cash from a recent sale is immediately available for new trades, but unless you wait for the original trade to settle, you risk violating this rule.
Analysis, not investment advice.