Free riding (also known as Freeriding or Free-riding) is a term used in the stock-trading world to describe the practice of buying
sharesor other securitieswithout actually having the capitalto cover the trade. This is possible when recently bought or sold shares are unsettled, and therefore have not been paid for.
Since stock transactions usually settle after three business days, a crafty trader can buy a stock and sell it the following day (or the same day), without ever having sufficient funds in the account.
Trade Day + 3 Days
United States, stocks take three 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
brokerto the customer. Because the transaction is considered a credit issue, the Federal ReserveBoard is responsible for the rule which is officially called Regulation T.
If a brokerage customer is approved for margin on the
accountthere 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.
Free riding Violation
Securities and Exchange Commissionstates "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."
If someone is trading rapidly and using all the cash available in the account to buy and sell, that person will likely get a "freeriding violation." Freeriding is subject to a mandatory 90-day cash-up-front restriction. Clients can still trade, but they lose the ability to make purchases with unsettled sale proceeds.
Good Faith and Free riding
The main difference between a
good faithviolation and free riding is the eventual deposit of funds to cover the buy. In free riding the buyer sells the security without ever depositing the funds to pay for the initial purchase.
Federal Reserveconsiders a good faith violation an "abuse of credit" and requires the broker keep track of them. If the trader gets three violations in one year, the broker is required to restrict the account. This is compared to the free riding violation which results in an automatic restriction.
Liquidation and Free riding
A liquidation violation occurs when the client sells a security to satisfy a cash obligation for the purchase of a different security after trade date. This is a violation because the sale of the second security will not be settled by the time the first purchase settles. A liquidation violation carries the same penalties as a good faith violation.
microeconomics, an agent is said to be free riding when it does not pay for its share of the cost of producing a public good. This may or may not be a problem. See the free rider problemfor further discussion.
* [http://www.turnertrends.com/articles/investment-questions/archive/What-is-a-Free-Ride.php What is a Free Ride?] : How Free Rides can affect your
Individual Retirement Account.
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