How to Avoid Good Faith Violations and What They Are

Good faith violations are a common pitfall for investors, particularly those trading in cash brokerage accounts. These violations occur when an investor sells securities purchased with funds that had not yet fully settled from a prior transaction. Understanding these rules helps investors avoid penalties and trading restrictions. These regulations ensure trades are properly funded and settled, maintaining market integrity. The timing of transactions is crucial for frequent traders to avoid violations.

Understanding Good Faith Violations

A good faith violation fundamentally arises from the concept of “unsettled funds” within a brokerage account. When you sell a security, the proceeds from that sale are not immediately available for unrestricted use. These funds are considered “unsettled” until they officially transfer from the buyer to the seller, a process known as settlement. For most stock and exchange-traded fund (ETF) transactions, the settlement period is currently one business day after the trade date, often referred to as T+1. This T+1 standard became effective as of May 28, 2024, shortening the previous T+2 cycle.

A good faith violation occurs when an investor uses unsettled proceeds from a previous sale to purchase new securities and then sells those newly acquired securities before the original funds have fully settled. These rules prevent investors from continually trading with uncleared proceeds. Brokerage firms are required to enforce these rules, which stem from federal regulations.

Common Scenarios Leading to Violations

Good faith violations frequently arise in cash accounts due to timing differences between a trade’s execution and its settlement. If an investor sells Stock A on Monday, the proceeds settle Tuesday (T+1). If they use these unsettled proceeds to buy Stock B on Monday, and then sell Stock B on Tuesday before Stock A’s funds settle, a good faith violation occurs. This happens because Stock B was sold before its purchase was covered by settled funds.

Another instance involves mixing settled and unsettled funds. If an investor has $5,000 settled cash and sells Stock X for $5,000 on Monday (creating $5,000 unsettled funds), then uses the total $10,000 to buy Stock Y on Monday, a violation occurs if they sell all of Stock Y on Tuesday. This is because half of Stock Y was bought with unsettled funds, and the entire position was liquidated before those funds settled. Selling only the portion bought with settled funds would avoid the violation.

Penalties for accumulating good faith violations can be significant. If an investor incurs three good faith violations within a rolling 12-month period, their cash account will be restricted for 90 days. During this restriction period, the investor will only be permitted to make new purchases using funds that are already fully settled in the account, which could significantly impact trading flexibility.

Strategies to Avoid Good Faith Violations

Preventing good faith violations primarily involves careful management of your cash account and understanding settlement cycles. The most straightforward strategy is to always trade with settled funds. This means verifying that the cash you intend to use for a purchase is fully settled before initiating a trade. Many brokerage platforms provide a clear indication of your “settled cash” balance or “cash available for withdrawal,” which represents funds that have completed their settlement period. Regularly monitoring your account statements and trade confirmations for settlement information is a practical step.

Another effective approach is to wait for funds to fully settle before using them for new purchases, especially if you plan to sell the newly acquired security quickly. Since most stock trades settle in one business day (T+1), if you sell a security on Monday, the funds will be settled and available for unrestricted use on Tuesday. If you buy a new security with those proceeds on Monday, plan to hold it until at least Wednesday to ensure the funds used for its purchase have settled. This deliberate waiting period can help you avoid inadvertently triggering a violation.

For investors who require more immediate access to funds or engage in frequent trading, considering a margin account can be an alternative. Margin accounts generally allow investors to trade with borrowed funds from their broker, which can circumvent cash settlement issues and good faith violations for trades placed on margin. However, margin accounts come with their own set of risks, including interest charges on borrowed funds and the potential for margin calls if the value of your securities declines. While margin accounts can help avoid good faith violations, it is still possible to incur them if trades are specifically placed using the “cash” trading type within a margin account. Always be aware of the specific trading type used for each transaction to avoid unintended violations.