In U.S. stock trading rules, investors using cash trading accounts need to be aware of the Good Faith Violation and the 90-Day Trading Restriction rules. These rules are mainly in place to regulate the buying and selling of unsettled funds.
U.S. stocks follow a T+2 settlement, meaning the transfer of stocks and cash appears instantaneous on our broker's backend, but in reality, it does not. Often, it's initially displayed as such, or the broker may front the funds, but the actual settlement still takes more time.
In this article, I will introduce the U.S. stock trading violation rules: What are the Good Faith Violation and the 90-Day Trading Restriction? What are the penalties for violations? And how can they be avoided?
Extended Reading: What happens in the event of a default settlement? What are the remedies for default settlement?
In this article, I will tell you:
1. Good Faith Violation and the 90-Day Trading Restriction only occur in cash trading accounts.
2. What does a Good Faith Violation entail?
3. Common scenarios of the 90-Day Trading Restriction.
4. How to avoid GFV and the 90-Day Trading Restriction?
5. Key points summary.
1. Good Faith Violation and the 90-Day Trading Restriction Only Occurs in Cash Trading Accounts.
In U.S. stock cash trading, there can be situations involving unsettled funds due to the T+2 settlement cycle. The actual debiting and crediting of funds happen 2 business days after buying or selling stocks. Although your account shows sufficient funds immediately after selling stocks, the real funds are only credited 2 days later.
These funds are usually advanced by the broker, but since the broker has not received the money yet, using these funds might be considered a violation.
Cash balances in the account are divided into two types:
Available Funds: Original deposited funds and funds from completed settlements.
Unavailable Funds: Funds from unsettled settlements (referring to funds from buying or selling stocks that have not been credited to the account yet).
When checking the actual settlement of funds, for example, in a broker's cash account, the 'cash buying power' amount changes immediately after the day's trades. However, the actual debiting and crediting happen on T+2, and it's not intuitively clear whether the settlement funds are available for use. Therefore, investors need to calculate the available funds themselves to place orders and avoid violation trades.
For investors with less financial flexibility, it's easy to inadvertently commit a violation. It is advisable to deposit more funds to increase financial flexibility, reduce the number of trades in a short period, or apply for a margin account to avoid penalties and restrictions.
2. What Does a Good Faith Violation Entail?
A Good Faith Violation (GFV) occurs when an investor buys stocks using funds that have not yet settled and then sells those securities before the funds have settled.
In other words, to receive a GFV violation notice, two conditions must be met:
Buying stocks with unsettled funds.
Selling those securities before the funds used to buy them have settled.
Under the T+2 system in U.S. stocks, it takes 2 business days for the transaction of stock buying and selling to settle.
Before T+2, although selling stocks increases the account balance, the money has not arrived; it only arrives after 2 days (meaning the funds have settled). Using this money before a settlement is considered a Good Faith Violation.
Note:
Settlement means that the stocks are officially transferred to the buyer's account, and the funds are officially credited to the seller's account, usually taking 2 trading days. For example, a transaction made on Tuesday will settle on Thursday.
T+2 means that the money or stocks will be settled in the account 2 trading days after the transaction day.
For example, suppose an investor sells Stock A for $2,000 on day T and uses $1,000 from the sale to buy Stock B, then prematurely sells the recently purchased Stock B. However, the funds from selling Stock A will take 2 business days to settle. Using these unsettled funds to buy other stocks constitutes a breach of regulations.
The correct approach is to wait for the funds from the sale on day T to settle after two business days, i.e., on T+2. If the investor sells Stock B purchased on T on T+2, it would not constitute a violation.
PS: What are the penalties for a Good Faith Violation?
If you violate the GFV more than 3 times within 12 months (starting from the 4th time), the broker will freeze your cash account for 90 days, also known as the 90-Day Trading Restriction.
Freezing doesn't mean you can't use the account, but it becomes somewhat like a full settlement-only account, where you can only trade after the funds or stocks have fully settled, which is equivalent to T+2.
In other words, during this period, the broker will no longer advance funds for you, and all trades must wait until the T+2 settlement is complete before they can be carried out again.
During the penalty period for a GFV violation, only settled funds can be used for trading, and the penalty does not expire until 12 months after the violation day.
3. Common Situations of the 90-Day Trading Restriction.
The 90-Day Trading Restriction is a penalty mechanism used by brokers. It can be imposed after multiple Good Faith Violation offenses or other types of violations.
Common situations that might lead to a 90-Day Trading Restriction include:
Having four GFV violations within 12 months.
Conducting stock trades using unsettled funds after a same-day offset trade.
Selling a stock without fully settling the payment within 5 business days.
If an investor faces a 90-day restriction, they can only create orders with funds that have fully settled.
Example 1: Same-day offset trade followed by another trade on the same day.
A same-day offset trade refers to buying and selling the same security within the same trading day.
If an investor conducts a same-day offset trade and then uses the unsettled funds from the first trade for another transaction on the same day, this constitutes a violation and can lead to a 90-Day Trading Restriction.
For example, on Monday, Mr. M, with a balance of $1,000 in his settlement account, buys and sells stock AAAA worth $1,000 on the same day. Then on Monday, noticing a price drop in AAAA, he used the funds from the recent sale of AAAA (unsettled funds) to buy AAAA again, worth $1,000.
Example 2: Selling securities before fully settling the purchase.
Another situation is selling stocks from a settlement account that doesn't have enough funds to cover the purchase, which can also trigger a 90-Day Trading Restriction.
For instance:
Mr. M has $100 in his settlement account on Monday and places a market order to buy stock AAAA.
The stock price suddenly spikes at the time of his order, leading to a transaction price higher than expected, with a final transaction amount of $120. However, his account only has $100, insufficient to cover the purchase. If he doesn't cover the shortfall of $20 within 5 business days and then sells stock A, he will face a 90-Day Trading Restriction.
4. How to Avoid Good Faith Violations (GFV) and the 90-Day Trading Restriction?
Methods to prevent triggering violation trades:
Method 1: The simplest way is to ensure that your account has sufficient cash balance to pay for the stocks you buy, without relying on unsettled funds.
Method 2: Reduce the number of trades within a short period.
Method 3: After a same-day offset trade, do not use unsettled funds to place new stock purchase orders on the same day.
Method 4: Trading using a margin account is another option.
Generally, GFVs occur most often among day traders or those engaging in same-day offset trades. To avoid GFVs, ensure that your account has sufficient funds. As long as you have enough funds, even if the funds from a stock sale haven't settled, you can still place orders with other available funds and won't be considered as using unsettled funds to place orders. In general, those who do not engage in frequent trading are unlikely to encounter this type of violation.
5. Key Points Summary.
5.1 GFV and the 90-Day Trading Restriction only occur in cash trading accounts.
5.2 A GFV violation occurs when an investor buys stocks with unsettled funds and then sells those securities before the funds have settled.
5.3 The 90-Day Trading Restriction means that for 90 days, only settled funds can be used for trading.
5.4 Situations that lead to the 90-Day Trading Restriction include violating GFV four times within 12 months, conducting trades using unsettled funds after a same-day offset trade, and selling a stock without fully settling the payment within 5 business days.
5.5 To avoid GFV and the 90-Day Trading Restriction, the simplest method is to ensure that your account has enough settled cash to pay for the stocks you buy before trading. Additionally, trading in a margin account can also prevent violations, but it's important to exercise proper risk management.
Note: Violating GFV is not a very serious issue.
The mistake investors make is trading again before the settlement of funds and stocks is complete, but the only cost the broker incurs is advancing funds before the settlement is finalized.
From the broker's perspective, they naturally do not want to frequently advance funds for clients, but it also does not have any severe adverse effects. Therefore, penalties are imposed only after four violations within a year, which is relatively lenient.
Thus, the consequence of GFV is merely a full settlement restriction, where the broker no longer advances funds for you. It only slightly reduces convenience and is not considered a severe penalty.
Of course, this is not to suggest that you should intentionally violate the rule, but rather to reassure you that if you suddenly see a GFV in your account, there's no need for excessive worry.
With careful attention, most people will not fall into the 90-day restriction.
And if you do encounter it, it might indicate that your trading is too frequent. Slowing down might be beneficial, as it suggests that what you might need is more adequate financial preparation.