What is 'Freeriding'

Freeriding is an illegal practice in which an underwriting syndicate member withholds part of a new securities issue and later sells it at a higher price. Freeriding also refers to the illegal activity of anyone buying a stock and selling it before paying for the purchase.

BREAKING DOWN 'Freeriding'

Due to the unfair advantage both of these types of freeriding practices give to those able to exploit such opportunities, freeriding is illegal and prohibited by the Securities & Exchange Commission (SEC) and the National Association of Securities Dealers.

The type of freeriding of which most people should be aware would be if someone buys a stock and sells it before paying for the purchase. Different types of securities have different settlement dates following a transaction; this is expressed as T, for "transaction," + however many days: T+1 (T+2,T+3). For stocks and exchange-traded funds, the settlement date is three days, or T+3; for mutual funds and options, it's one day, or T+1.

Investors trading in broker-administered margin accounts are less likely have trouble because the broker lends the customer cash to cover the transaction, thereby providing protection against violations like freeriding. In a cash account, this isn't the case. Therefore, it's imperative that an investor has enough cash to pay for the purchase of a stock on the due date. If the investor tries to offload the stock before settlement, the account will be in violation and frozen for 90 days.

Example of Freeriding

Here's an example of freeriding in a cash account:

  • You sell shares of Boston Scientific Corp. on Monday;
  • With the cash from the sale of BSX, you buy shares of Johnson & Johnson (JNJ) on Tuesday;
  • You sell the JNJ shares on Wednesday;
  • Your sale of BSX shares settles on Thursday. 

Because settlement for the BSX transaction didn't occur until Thursday (T+3), there was no cash to cover the purchase of JNJ on Tuesday and sale of those shares on Wednesday. To avoid freeriding, the investor would have had to wait until settlement (Thursday) before offloading the JNJ shares.

As this example illustrates, an active trader could easily find himself in violation of freeriding rules if they don't fully understand cash account trading rules. One of the biggest problems with freeriding is that many investors don’t know they're doing it or that the possibility of doing something unlawful like this even exists. For this reason, it's important to become familiar with how freeriding works — and the SEC rules that prohibit the practice.

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