What Is Freeriding

Freeriding, in stock trading, describes buying and selling stock without having the money to cover the trade. It also refers to an illegal practice in which an underwriting syndicate member withholds part of a new securities issue and later sells it at a higher price.

Key Takeaways

  • Freeriding describes the stock-trading practice of buying and selling shares without having the actual cash on hand.
  • It also refers to 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 laws are often violated by traders who do not know of or understand them.

How Freeriding Works

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 is one day or T+1.

Investors trading in broker-administered margin accounts are less likely to 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 is not the case. Therefore, it is 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 is 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 did not 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 he does not fully understand cash account trading rules. One of the biggest problems with freeriding is that many investors do not know they are doing it or that the possibility of doing something unlawful like this even exists. For this reason, it is important to become familiar with how freeriding works — and the SEC rules that prohibit the practice.