Exemplar Prep
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What a cash account can and cannot do

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No credit means no short sales — and yet a covered call is perfectly allowed.

The ruleCash account: no credit, so no short sales and no buying on borrowed money. Freeriding — selling before paying — withdraws the privilege of delaying payment for 90 calendar days. A covered option transaction is permitted.

Paying for it, and what happens when you do not

The defining feature of a cash account is that the firm extends no credit. Every purchase is paid for in full, and the customer owns the securities outright. Almost every consequence in this lesson follows from that one fact, so it is worth holding on to: if a transaction depends on borrowing money or borrowing stock, a cash account cannot do it.

Keep reading: 4 more paragraphs (about 2 min)

The failure that has a name is freeriding: selling a security, or delivering it away to another firm, without ever having paid for the purchase. The customer takes the profit on a position they never funded, and the firm carried the money in the meantime. The consequence is neither a fine nor the closure of the account. The privilege of delaying payment beyond the trade date is withdrawn for 90 calendar days, so during that period a purchase can only be made where the account already holds enough money to pay for it.

The restriction is escapable in one way, and it is worth knowing because it is the same fact from the other side. If full payment is received inside the payment period (the settlement cycle plus two business days, which is three business days after the trade under T+1) — or a check clears — and the proceeds of the sale are not withdrawn before that happens, the 90-day restriction does not apply. The rule punishes the unfunded position, not the speed of the trading.

That is the distinction candidates most often lose. Day trading describes buying and selling the same security within a day, which is a pattern of activity. Freeriding is a failure to pay. A customer can day trade all week in a properly funded cash account and freeride nothing; a customer can freeride once, on a single leisurely round trip, and be restricted for three months.

Finally, the things a cash account can still do. It can sell securities the customer owns, including securities not yet in the account where the customer states they are owned and will be deposited promptly. And it can be used for a covered option transaction: a call written against shares held in the account is expressly permitted, because the shares that would have to be delivered are already there. What it cannot do is sell short, because that requires borrowed stock, or buy on credit, because that requires a loan.

Exam terms (6)
Cash account
An account in which no credit is extended and every purchase is paid in full.
Freeriding
Selling a security that was never paid for.
90-day restriction
Purchases need sufficient funds in the account first, for 90 calendar days.
Payment period
The settlement cycle plus two business days; with T+1, three business days after the trade.
Covered option transaction
An option written against the underlying position held in the account.
Day trading
Buying and selling the same security within a day; a pattern, not a payment failure.

Inside a cash account

PermittedNot permitted
BuyingPaying in full for the purchaseBuying on credit from the firm
Selling what you ownSelling securities held, or stated to be owned and to be deposited promptlySelling a security you never paid for
OptionsA covered option transactionWriting a call with no underlying position
Short salesNoneSelling short, which needs borrowed stock
After a freeriding violationBuying with funds already in the accountDelaying payment beyond the trade date, for 90 calendar days
Everything permitted here is something you can do without borrowing.

Try it: Decide which of these a cash account allows, before reading on: writing a call against 100 shares already in the account; selling 200 shares the customer holds a certificate for and will deposit tomorrow; selling short 100 shares of an overvalued stock; buying $5,000 of stock with $3,000 in the account and the rest to follow next month. Three of the four have a clear answer from one fact alone.

Check yourself

Try a question, then read the explanation to review the rule.

Opening your study record…

Worked example

A customer buys $10,000 of stock in a cash account on Monday and sells it on Wednesday for $10,800, having sent no money at any point.

  1. The purchase was never funded, and the sale has already happened. That is freeriding, whatever the customer intended.
  2. The consequence is not a fine and not the closure of the account. For 90 calendar days the account may not delay payment beyond the trade date.
  3. In practice that means the next purchase can only go through if the money is already sitting in the account when the order is entered.
  4. Now change one fact: the customer wires the full $10,000 inside the payment period and leaves the sale proceeds untouched until it arrives. The restriction does not apply, because the position was funded after all.
  5. Change a different fact instead: the customer pays for everything on time but buys and sells the same stock three times in a week. Nothing here is freeriding, and no restriction follows.

Same rule, new context

Opening your study record…

The closest contrast

Freeriding: a failure to pay.

Day trading: a pattern of activity.

Only the first restricts the account, and it can happen on a single trade. The second can happen every day in a fully funded account and breaks no cash-account rule at all.

Summary

  • A cash account extends no credit, so short selling and buying on borrowed money are both out.
  • Freeriding is selling a security that was never paid for.
  • The consequence is a 90 calendar-day withdrawal of the privilege of delaying payment, not a fine.
  • Day trading is a pattern of activity and is not freeriding.
  • A covered option transaction is permitted in a cash account.

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