Spark Global Limited Reports:
When trading stocks or other securities in a cash account within the day, it is important to know the rules to avoid possible violations. This includes breach of trust.
Before your first day of trading, you need to decide whether you intend to trade on a margin basis or in a cash account.
Today, we will look at cash accounts and good faith breaches (GFV) that apply to these types of accounts.
What is a cash account?
If you want to buy or sell stocks, the first step is to open an account with a reputable online broker.
Popular U.S. brokerage firms include Lightspeed, Robinhood, Ameritrade, E-Trade, Charles Schwab, TradeStation, Interactive Brokers, and more.
Once you choose a broker, you have two options: a margin account or a cash account.
A margin account is a trading account that allows you to borrow money from a broker to buy stocks on margin.
With a margin account, you will have twice the purchasing power of a cash account, which will give you the opportunity to trade on a larger scale and generate more profit.
The cash account is easy. With this account, you can only trade with the money you have. Unlike a margin account, you can’t use a cash account to borrow money from a broker.
For example, if you have $1,000, you can only buy $1,000 worth of stocks and can’t borrow more money from a broker by using shares in your cash account as collateral.
While cash accounts don’t give you enough purchasing power, one of the biggest benefits of using them is that you can help prevent huge losses, which is even more important if you’re an active trader.
The settlement date
Before we delve into breaches of faith, it is important to explain how stocks or other securities are paid. When you buy or sell stocks, your trade occurs immediately.
However, even if your newly purchased stock now appears in your brokerage account, the trade is not settled. Market rules allow transactions to be considered official for several days.
The settlement date is the date when a transaction is finalized and the buyer must pay the seller and the seller delivers the margin to the buyer.
For options and government securities, the settlement date is usually the next business day (T+1). For stocks and bonds, it is two trading days after the execution date (T+2).
What is a breach of faith?
A good faith breach occurs when you buy and sell shares before the funds used to buy them have settled. Only sales of securities or cash paid in full are eligible for settlement funds.
The reason that liquidating a position before paying with settlement funds is called a “good faith default” is that the necessary cash was not deposited in good faith before the settlement date.
What is an example of a breach of faith?
The following example demonstrates how a hypothetical trader (Jim) can lead to a breach of faith.
Let’s say Jim has $0 in his cash account.
On Monday morning, he sold Apple (AAPL) stock for a $5,000 cash gain. Later that afternoon, Jim bought Tesla (TSLA) shares for $5,000.
If he had sold TSLA shares before Wednesday, the settlement date for the deal with Apple, the deal would have been considered a breach of good faith because he did not have enough money in his account to buy TSLA shares.
Let’s say Jim has $1000 of tradable cash in his cash account minus cash credit for outstanding activities = $500 (proceeds from stock sale on Friday – trading closes on Tuesday)
On Monday morning, Jim bought TSLA shares at $1,500. If he sold later in the day, it would be a breach of faith.
Because the $500 gain was not considered sufficient funds until Tuesday’s settlement, the stock purchase was not considered fully paid.
Let’s say Jim has a cash balance of $2,000. Then, on Monday morning, he bought $2,000 of TSLA shares.
By late afternoon, he sold the stock for $2,500. As the market was closing, Jim bought $5,500 worth of Apple stock.
At this point, no breach of good faith occurred because he had sufficient funds to buy TSLA shares. But if he had sold the apple stock before paying the settlement, it would have been a breach of good faith.