Editor's Note: Ask TheStreet is designed to answer questions about the market, terms, strategies and investment methods. Please email us to ask a question, but keep in mind that we cannot offer specific investment- or stock-related advice.
I recently requested information from an online broker and received a packet in the mail with an application that included terms and conditions. While reading, I came across something called "freeriding" that I did not understand. Based on what I understood the meaning to be, how can an investor move in and out of a position quickly and not be a "freerider"?
For example, say I buy 1,000 shares of a stock at $10 apiece. During the trading day, the stock goes to $11.50. I sell at $11.50 the same day, thus making $1,150. How do you avoid being a "freerider" while taking a decent profit? Thanks, J.W.
There's nothing wrong with taking a profit. In fact, we're all for it. But you have to pay for the pleasure, or else you'll be put in the proverbial penalty box.
In a cash account, you must pay for the purchase of a stock before you sell it.
If you buy and sell a stock before paying for it, you are freeriding, which, according to the
Securities and Exchange Commission
, violates the credit-extension provisions of the
The penalty for freeriding is a freezing of your account for 90 days.
In other words, your broker will still allow you to trade freely, but you must pay in full for any stock purchase the same date on which you trade during the 90-day freeze window.
One drawback to being in the penalty box is that you won't get the benefit of having three days to settle your trade.
Investors must settle their security transactions in three business days, or what is commonly referred to as T+3 -- shorthand for "trade date plus three days."
Under the T+3 rule, when you buy a stock, the brokerage firm must receive your payment no later than three business days after the trade is executed.
Another -- entirely separate -- definition of freeriding on Wall Street concerns the new-issue, or IPO, market. In this context, freeriding is an illegal practice whereby one of the investment banks underwriting the IPO stashes away a chunk of shares from the deal in order to sell it later at a higher price.
However, investment bankers who engage in this type of freeriding won't go to the penalty box for a mere 90 days: The punishment for that offense is far stricter.