Break It Down: How To Avoid Cash Trading Violations?

Break It Down: How To Avoid Cash Trading Violations?

What is Cash Trading?

Cash trading is one that requires buying securities with the money available in the investors’ account rather than depending on borrowed capital, unlike margin trading. Online share trading in cash requires that all the transactions are paid for, at the time of settlement, with the help of funds present in the investor’s account.

Benefits of Cash Trading

  1. Disciplined way of trading: Since the entire money has to be paid, the chance of a person going above the limit is almost nil to negligible. Losses can also be controlled in case If the prices go down. 
  2. No time limit:  The trader can hold the shares and securities as they want and can decide to sell when the holding reaches a desired price.
  3. Safe and hassle free: Online share trading in cash is safe, hassle-free, less risky and an excellent choice for new traders.

While the only disadvantage is that exceptionally high brokerage and taxes (ten times higher than margin trading) are needed to be paid along with the full price of the security.

What are Cash trading Violations?

The settlement period for online share trading in cash is industry-specific for a trade of stocks, mutual funds, upcoming IPO, options, etc. For a sale in the case of cash trading, the money needs to be settled before it can be used for another trade. (mostly 1-3 business workdays). If a new trade is done before the settlement period, with unsettled cash from the previous sale, the violation has taken place. Generally, there are 3 types of violations that can take place are as follows:

  • Good faith Violation: is one in which a security is purchased (for example- an upcoming IPO) with the unsettled proceeds from a previous sale and this new security bought, is in turn sold before having paid for it. Since no effort has been made to deposit additional cash in the account before the settlement date, a good faith violation has occurred.
  • Free Riding Violation: This kind of violation occurs when a security is bought from the sales proceeds of the same security. Here violation of the T regulation of the Federal Reserve Board (FDR) has taken place regarding broker-trader credit. For e.g. A person doesn’t have money, goes ahead and buys securities worth INR 25,000/- The payment for this purchase is not made till next two days. Then on the third day, the same securities are sold for INR 35,000/- to cover for the purchase. Here  a freeriding has occurred as the stocks were not fully paid before they were sold.
  • Cash Liquidation Violation: The violation occurs when securities such as an upcoming IPO are bought and to cover the cost of purchase, other fully paid securities are sold after the initial purchase date. According to the prevailing rules of the brokerage industry, one should have sufficient settled cash in his/her account on the settlement date to cover for purchases.

Avoiding Violation of rules – How

  • Ensure there is enough settled cash in the account to cover for purchases before trades are placed. 
  • Make sure that there is required cash to cover up for fluctuations in the price of the security and fees charged like commission, brokerage, taxes etc.
  • Make additional cash deposits in the account or sell a different security beforehand to have enough settled cash at the time of the order.

It is easy to understand Demat meaning. It is quite understandable for an active trader to encounter problems if he does not fully understand cash account trading rules. To avoid breaking such rules, It is important to maintain sufficient settled funds to pay for purchases in full by the settlement date. For instance, if a violation takes place three times, there is a possibility of the account being restricted.

Also read:- What Is The Role Of A Demat And Trading Account?