Free riding is buying and selling a stock without paying for it -- essentially using the broker’s resources to make money without putting up any of your own capital. Free riding is illegal, and brokers are especially sensitive to it because it puts them at risk of loss if a trade goes bad and the customer does not pay for it.
How It Works
Stock trades settle in three business days -- that is, you have three business days to pay for a stock purchase. A person can open a cash brokerage account with no money down, put in an order to buy 500 shares of XYZ at $50 and pay for the purchase by depositing $25,000 three days later. However, if he sells XYZ two days later for $52, before the payment is due, he will have $26,000 coming to him in three business days: $25,000 would cover the purchase and $1,000 would be the profit -- with no money down. If, on the other hand, XYZ drops to $48, the customer could walk away from the transaction without paying for it, saddling the broker with a $1,000 loss.
Free riding is a violation of the Federal Reserve Board regulations of the credit that brokers can extend to customers for stock purchases. A violator’s account must be frozen for up to 90 days. In the worst cases, free riders face criminal prosecution by the Securities and Exchange Commission.
Good Faith Violations
The biggest potential for violations comes from new accounts. An existing customer with a balance in the account is much less likely to abuse the system, although he might occasionally get caught up in frequent trading, covering a trade a day or two later than required. Brokers must keep track of such “good faith” violations.
Preventing Free Riding
The best protection against free riding is prevention. Most brokers nowadays insist that a new customer deposit funds when opening an account, before accepting any trades. If an existing customer “free rides,” the broker will not release the proceeds from the trade until the customer fully pays for the purchase and may simply shut down the account to be on the safe side. Frequent buying and selling before settlement is most likely to occur in a day-trading account, which must be approved by the broker in advance and maintain a minimum of $25,000 in equity before any trades can go through.