Freeriding: Definition, How It Works, Legality, and Example

What Is Freeriding?

The term freeriding refers to the practice of buying shares or other securities in a cash account and then selling them before the purchase has settled. When a trader freerides, they may pay for the shares using money from the proceeds of the sale instead of cash. Freeriding is a violation of the Federal Reserve Board's Regulation T and may result in the suspension of the trader's account.

Understanding Freeriding

Regulation T (Reg T) is a series of provisions that govern how investors can use their cash accounts when they trade, as well as how much credit they can receive from brokers and dealers to execute their trades. One of the federal regulations stipulated by the Fed under Reg T is that investors must have enough capital in their cash accounts to buy securities before they are sold.

Freeriding usually happens when a trader buys and sells a security without having enough capital in their account to cover the purchase. But how is that possible? Different securities have different settlement dates following a transaction. This is expressed as T plus the number of days it takes to settle. For instance:

• Stock and exchange-traded fund (ETF) transactions settle in two business days (T+2)
• Mutual fund and options transactions settle in one day (T+1)

Let's say a trader buys shares in a company. The sale settles two days after the date of purchase. When they sell their shares, their account is almost always credited immediately with the proceeds. The trader can then use those proceeds to cover the original purchase when it settles. Basically, the trader sells the shares before they actually buy them.

This practice is illegal and is prohibited by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Brokers and dealers must freeze any cash account they suspect of freeriding for a 90-day period. When an account is restricted, a trader may still buy securities, but the purchase must be done using cash on the very same day rather than on the settlement date.

Traders may be unintentionally guilty of freeriding if they buy securities with the proceeds of a sale that has not been finalized. For example, imagine a trader who sells $100 of a stock and uses the proceeds to buy another stock the following day. Since stock trades take two business days after the sale to settle, that trader was freeriding, because the first sale would not have been finalized for an additional business day. Under federal regulatory guidelines, their cash account should be frozen for 90 days.

As mentioned above, investment bankers and broker-dealers who act as an underwriting syndicate may also be in violation of freeriding when they keep shares from an initial public offering (IPO) aside so they can sell them for a higher price at a future date.

Special Considerations

You can commit freeriding even if you have enough cash to pay for a purchase. Under the law, freeriding describes any sale that takes effect before the purchase is settled, whether or not the trader already has enough funds on hand.

Traders can use a margin account to avoid the potential of freeriding while you trade. A margin account is a loan issued to an investor by a broker or dealer so they can conduct trades. The securities purchased using the account and any cash deposited by the investor act as collateral. In turn, the investor agrees to pay a certain amount of interest on the loan.

Investors who trade 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 freeriding violations.

Example of Freeriding

Here's a hypothetical example to show how freeriding works. Let's say you own shares of Boston Scientific (BSX) and (for simplicity's sake) you have no other holdings or cash in your account. On Monday, you decide to sell shares. You then use the cash from the sale to buy shares of Johnson & Johnson (JNJ) on the same day. Then, you decide to sell the JNJ shares on Tuesday—a full day before the sale of your BSX shares settles.

Because settlement for the BSX transaction did not occur until Wednesday (T+2), there was no cash to cover the purchase of JNJ and the sale of those shares. To avoid freeriding, the investor would have had to wait until after settlement (Thursday) before offloading the JNJ shares.

As this example illustrates, active traders could easily find themselves in violation of freeriding rules if they do not 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 like this is illegal. For this reason, it is important to become familiar with how freeriding works, as well as with the SEC rules that prohibit the practice.

Correction–Feb. 27, 2022: This article has been edited to highlight some circumstances where freeriding can occur.

Correction–Feb. 10, 2023: A previous version of this article misstated the settlement date or BSX in the example. This was corrected to read Wednesday instead of Thursday.