Going for Broke(r): Discovering Brokerage Options

Exploring Types of Brokers and Brokerage Services

Before you can pick the type of broker that best fulfills your needs, you need to understand the kinds of services that each kind of broker provides. After you gain an understanding of your options and select the types of services you want, you then need to carefully research each of the brokers that match your needs. Within each classification are good and bad brokers. We give you the tools for researching brokerage firms in the sections that follow.

Full‐service brokers

If you want someone to assist you with buying decisions and implementing those decisions, you need to check out full‐service brokers. They offer extensive research and other services. Usually, they call you with trading ideas. All you need to do is say yes or no. You pay a transaction fee for trades plus a commission percentage based on the dollar volume. You can invest in stocks, futures, options, bonds, mutual funds, money‐market funds, and variable annuities. You can work with a full‐service broker by telephone, mail, fax, or Internet. Most have websites you can access for information, and many allow you to enter your own trades.

Here is an example transaction fee schedule for one of the better‐known full‐service brokers (others can be as much as twice as high):

Transaction Size	Commission Rate
$0–$6,000	2% of principal
$6,001–$10,000	$30 plus 1.5% of principal
$10,001–$25,000	$80 plus 1% of principal
$25,001–$100,000	$205 plus 1% of principal

Alternatively, some full‐service brokers do permit you to make all the trades you want per year for a fee of 0.30 percent to 2.5 percent of the total assets in your brokerage account. Using language common to traders, that’s 30 to 250 basis points. You have to have more than $10 million in an account to get the lowest fee. Traders with less than $100,000 pay closer to the 2.5 percent of assets to access the unlimited trading features.

Just because you choose to use a full‐service broker doesn’t mean you can just sit back and let your money grow after placing it into an account. Brokers make money on commissions for the exchange of stocks. If they have no transactions during a given month, they don’t get paid. Unscrupulous brokers recommend trades to their customers to generate new commissions even when those decisions are not necessarily the best investment advice for their clients. This practice is often referred to as churning.

Even the research arms of many full‐service brokerage houses are scrutinized by the Securities and Exchange Commission (SEC) primarily because their analyses didn’t accurately reflect the values of stocks in companies that used the firms’ investment‐banking capabilities in the past. Analysts tend to see their firms’ clients through rose‐colored glasses when providing research reports, especially when their firms make a lot of money by providing investment‐banking services to those companies. We talk about changes that have been implemented to improve analyst services in Chapter 7.

Just because you choose to work through a full‐service broker doesn’t mean you can sidestep doing your own research. You always need to perform due diligence, independently researching your stock purchases. Although you certainly can use the research arm of your brokerage firm, it shouldn’t be your sole source of research on any stock you’re thinking about buying or that you already hold.

If you’re planning to be a trader, then do your own research and implement your own trading strategies. Why pay for the services of a full‐service broker? We really don’t recommend that you waste your money on the additional costs of maintaining a full‐service brokerage account or paying the high transaction fees and commissions.

Discount brokers

Many discount brokers offer the same services as full‐service brokers, including research. The big exception is that you don’t get individual attention or unsolicited advice on what to buy or sell. Some discount brokers send out monthly newsletters with stock recommendations; most don’t trade futures or sell variable annuities. You can access a discount broker by telephone, mail, fax, or Internet. To get the lowest fees on trades, you need to do your own trades by accessing the broker’s website.

The big difference to you, as an individual trader, is that you can save a lot of money on trading costs, provided you know what you’re doing and you understand the language of stock trading. Transaction fees for online trades can range from as low as $5 up to about $30 with a discount broker. If you want special services requiring a broker’s assistance, you can work with a human being. Depending on the discount brokerage firm and the level of service required, fees can range from $25 to $50 per trade. Some discount brokers provide broker‐assisted trades using a commission rate schedule similar to the ones offered by full‐service brokers, but it has lower fees per trade. If you get involved in more‐complicated trading transactions that require human assistance, costs can rise significantly. Anytime you’re planning to use a broker’s assistance, be sure you understand any additional costs that may be charged to your account for that assistance.

Direct‐access brokers

If you want to bypass the traditional brokers and trade directly through an exchange or market maker, you need to open your account with a direct‐access broker so you can use one or more of the electronic communications networks (ECNs) to make your trades. Traders usually download software onto their PCs so they can access the ECN directly using their Internet connections.

Traders using direct‐access brokers typically get real‐time NASDAQ Level I quotes, which show the latest bid and ask prices, quote size, last trade, and volume.

Direct‐access brokers also offer NASDAQ Level II access. NASDAQ fees are higher for Level II, and the brokerage may also charge an additional fee for this type of access. In addition to what you see in a Level I quote, you also find the number of market makers participating in the market for any one stock.

A NASDAQ Level II quote screen shows the best bid price and the best ask price for specific stocks from participating market makers. All the bid and ask prices are ranked from best to worst. Some direct‐access brokers combine NASDAQ Level II information and ECN book data to show the complete market depth for a specific stock. The ECN book isn’t a printed book like you would expect to find on a bookstore shelf. It’s a compilation of all the trades and the bid and ask quotes available on all the electronic networks.

Traders can review the quotes and select which market maker or ECN to use for each transaction. Most full‐service and discount brokers make that choice for you when you’re working with them. A few discount brokers are providing access to ECNs.

When working with direct‐access brokers, one key difference is that the software you use may reside on your own computer and not on your broker’s server, which greatly accelerates the speed at which you can trade. Again, some discount brokers provide software to enable you to receive direct raw data on your home computer, but their software isn’t as sophisticated as what direct‐access brokers have to offer. We cover software issues in detail in Chapter 4.

We often talk about how you can miss trading at the prices you want, especially in fast‐moving markets. Well, having direct access doesn’t guarantee that you won’t miss a price, but your chances of catching those prices are better because you don’t have to wait for pages to download from your broker’s server. Of course, for this advantage to work for you, you must have high‐speed Internet access, which can include DSL, cable, or satellite access.

Working with a direct‐access broker gives you a steady stream of raw financial data — the actual trades, current bid and ask prices, trading volume, and market statistics. The trading software that you load onto your computer determines how this data is organized and presented on your computer monitor. Providing better access is how direct‐access brokers distinguish their services from other brokers.

Software prices and access fees vary greatly and can cost you as much as $300 per month. The fees sometimes can be waived, especially if your trading volume is high enough — typically about 50 or more trades per month. As you can see, you have to make regular trades for a direct‐access broker to be more cost‐effective than a discount broker. That said, even some discount brokers offer limited direct access using less‐sophisticated software.

Proprietary trading firms

Proprietary (or prop) trading firms enable traders to use at least some of the firm’s capital in addition to or instead of their own. Depending on the firm, traders share the gains and may (or may not) share the losses. You can’t just walk in and expect to trade with one of these firms. You must have an NASD Series 7 license combined with a proven history of trading in the equity markets. Some proprietary trading firms may also require that you have a Series 55 and Series 63 license. The firm you work with trains you in its trading style, but proprietary trading is not usually an option for beginners. Some proprietary trading firms do offer to bring in beginners or relatively inexperienced traders to train who don’t meet licensing requirements upfront, but the fees for this training can be steep.

Futures brokers

Unless you’re working with a full‐service brokerage firm, you may have to open a separate account with a futures broker if you want to trade commodities or other types of futures. Futures brokers must be licensed by the NASD in a way that differs from stockbrokers. Many direct‐access brokers provide futures brokerage services, but you can’t always find them at a discount broker. We talk more about trading futures in Chapter 19.

Services to Consider When Choosing a Broker

You can’t choose your broker purely on the basis of price. You need to know what types of services are offered to enable you to make the types of trades you want to make. When researching brokers, check out the types of orders supported, whether they can offer you data tools, what types of charts they provide, and whether they can give you ECN access if you want to make your own trades electronically.

Types of orders supported

As we mention in Chapter 2, not all brokers provide stop orders for OTC and NASDAQ trades. The NASDAQ has no facility for handling stop orders, so the broker must monitor your stop prices and enter either market or limit orders if your price is triggered. Although monitoring stop prices usually is done automatically, not all brokers offer the service. If you know you’ll be using stops with many of your trades, you need to find a broker who provides those services. Some discount brokers provide those services if you’re willing to pay for them.

As such, you also need to compare not only prices for those services but also the respective brokers’ reputations for effectively and efficiently providing those services. If you want to place contingent orders (see Chapter 2), you may discover that few discount brokers offer that service, even for a price.

As you trade, you definitely need to steer clear of brokers who accept payment for order flow, a practice in which some exchanges or market makers pay brokerage firms for routing orders to them. Firms can make a penny or more per share, but the SEC requires the firm to inform you whether it receives payment for order flow when you first open an account and thereafter on an annual basis. Each time a firm receives a payment for order flow, it must disclose that information on the trade confirmation. If you see an indication on one of your trades that your broker received this type of payment, you have the right to request notification in writing about the source and type of payment related to that transaction. These payments may encourage unethical brokers to steer orders away from the best prices and toward the market maker offering such payments.

Data tools

The type of data to which you want to have access is crucial. Most brokers provide basic stock quotes, usually in real time, and some may even offer market data providing a much deeper look at the market that includes not only current sales information but also previous sales information. If you want access to a higher level of data, you need to open your brokerage account with a firm that provides the level of data that you need, or you may buy it from a third party. Again, pricing for differing data tools can vary among brokerage firms. Firms that offer you ways of getting this data through your home computer (as opposed to accessing it from their servers) charge more, but you’ll receive the information quicker. The faster your Internet connection, the more quickly and reliably you receive this information. Data feeds may also include critical tools such as stock screeners, option analytics, rating service information, and news feeds. We cover data tools in greater detail in Chapter 4.

Charts

Data fed into your home computer is raw stock‐market data. How this information is formatted on your computer and which charts you’re able to build from it depend on the software that your broker provides. Charting software can be critical to your ability to make trading decisions. Your broker may charge you to use the software but usually discounts or waives the fee based on the size of your portfolio or your volume of trading activity.

Many free charting alternatives are available online, including StockCharts.com, which we used to produce the charts for this book. We talk about charting capabilities in Chapter 4.

ECN access

If direct access to stock exchanges and market makers is important to you, then you need to find a broker that provides ECN access. You don’t have to open an account through a direct‐access broker; some discount brokers do provide ECN access. Be sure to check out the section “Choosing the Right Broker for You,” later in this chapter.

Knowing the Types of Brokerage Accounts

You can open your brokerage accounts in a couple of different ways: as a cash account or a margin account. However, if you open a margin account, you also must open a cash account. You also may open separate accounts for retirement savings. Because retirement accounts have more restrictions, your trading alternatives are more limited in those accounts, but that isn’t necessarily a bad thing. You shouldn’t be risking your retirement funds on speculative trading anyway.

Cash accounts

The traditional brokerage account is a cash account, which also is known as a Type 1 account. With a cash account, you must deposit the full cost of any purchases by the settlement date of the transaction. At many brokerage houses prior to 2002, you were permitted to place an order to buy stock even if the cash was not yet in your account. As long as the money was deposited within three days of the completion of the transaction, you could make the purchase. Today, however, few brokers give you that kind of flexibility. Most brokers require funds to buy stocks to be in your cash account before you can place an order. The amount of cash you need to have on deposit varies by broker; some let you open an account for as little as $100 or $1,000, but others require as much as $10,000 or more to open a new cash account.

Margin accounts

You don’t have to have as much cash on hand to buy stock when you open a margin account, which also is known as a Type 2 account. This type of account enables you to borrow certain amounts of money using cash or securities already in the account as collateral. Because using a margin account essentially is buying stocks or bonds on credit, each respective brokerage firm has its own screening procedure to determine whether you qualify for the loan and can buy on margin.

The Federal Reserve requires a $2,000 minimum deposit to open a margin account, and it currently limits the amount you can borrow on margin to 50 percent of the initial purchase price. Not all stocks can be bought on margin. Some brokerage firms enforce even stricter margin rules, especially if you choose to invest in volatile stocks. When buying stocks on margin, you pay an interest rate on the margin loans, but most brokerage firms charge relatively low rates to encourage the transaction business. Be sure to check out the “Margin requirements” section later in this chapter.

When opening a margin account, the firm also requires you to sign what’s called a hypothecation agreement, which stipulates regulations for the account and permits the broker to have a lien on your account whenever the balance in your account falls below the minimum maintenance margin (more about that in a moment). The agreement also enables your broker to loan your shares to short sellers. That’s where shorted stock comes from. We talk more about short selling and the mechanics of margin trading in Chapter 15.

You’re taking a risk by purchasing shares of stock with borrowed money and using shares you own as collateral. If your stock holdings fall in value below the minimum maintenance margin requirement, your broker can force you to sell stock you don’t want to sell and use other assets you may not want to use to cover the outstanding loan. The risks and regulations for using a margin account are described more fully in the section on margin requirements, later in this chapter.

Options

If you want to trade options, your broker will require you to sign a special options agreement acknowledging that you understand the risks associated with trading options or derivative instruments. This practice became common after brokers were sued by some clients because they suffered huge losses when trading options and claimed they were unaware of the risks. The agreement protects the broker from being sued if you lose a lot of money, so you need to know what you’re doing when dealing with derivatives (see Chapter 19).

IRAs and other retirement accounts

IRAs and other accounts in which you’re saving for retirement — such as 401(k)s or 403(b)s — sometimes allow you to trade options, but margin trading is not allowed at all. These limitations are for your protection to avoid risking major losses in your long‐term investments that never should be put at such high levels of risk. The Internal Revenue Code limits the amount you can contribute each year to all retirement accounts.

Although you may be able to find a brokerage firm that allows you to trade using options — puts and calls, which are a type of option (see Chapter 19) — you nevertheless risk penalties for certain trading activities that occur in your retirement account whenever the IRS determines the account is being used for trading purposes rather than long‐term investing. Officially, the Internal Revenue Code prohibits the “IRA or Keogh Plan account holder from loaning money to the account. Likewise, the holder cannot guarantee borrowing by the account or cover its losses.” That’s why margin accounts, which entail a type of borrowing, aren’t allowed.

Because these accounts are either tax‐free or tax‐deferred, you can’t write off any losses in them against any gains from investments held outside of them in other taxable accounts. In other words, you don’t have the same tax‐planning choices with IRAs or retirement accounts to offset gains and losses. All money taken out of an IRA at retirement is taxed at your current income tax rate. This differs from stocks held outside an IRA. For these stocks, you can use stock losses to minimize the tax you may have to pay on stock gains. If you hold the stock for longer than a year, you’re taxed based on the lower capital gains rate of 15 percent for most taxpayers (some low‐income taxpayers qualify for a rate as low as 0 percent) rather than your higher current income tax rate, which can be as high as 35 percent for some taxpayers.

Here are some additional trading limitations of retirement accounts:

Margin is not allowed. Using funds within a retirement account as collateral for trading on margin isn’t permitted. It’s against the law. You won’t find a broker that will permit you to place retirement funds in margin accounts.
Short positions are prohibited. Speculative trading using short positions, which is a common trading strategy for futures contracts and widely used by experienced stock and bond traders, requires a margin account. When someone shorts a stock, he or she borrows the stock and sells it in the hope of buying it back later for less. Selling short requires the use of margin and is therefore not permitted in a retirement account. We talk more about short selling in Chapter 15.
Trading policies are more stringent. All brokers have more stringent trading policies for retirement accounts. Before you open a retirement account, check with your broker about its trading limitations to be sure they match your intentions for the account.
Options trading may not be permitted. If you’re an experienced trader, you can find some brokerage firms that allow options trading in your retirement account. Not all types of options, however, can be traded in a retirement account. The ones that you most likely can trade are covered calls, long call and put positions, or cash‐secured puts. We talk more about puts and calls in Chapter 19.

Choosing the Right Broker for You

Before beginning a search for the right broker, you must first decide what type of trader you want to be and what services you need. If you want to be a position trader, or one who trades infrequently, your best bet is either a full‐service or a discount broker. Making the choice between full‐service and discount brokers depends on how independently you want to operate as a trader. If you want advice on your stock‐investing plans, you need to seek out a full‐service broker, but we certainly don’t recommend this expensive option. Before risking your money on trading, however, you need to be comfortable enough with the language and mechanics of trading and how to conduct your own research. If you don’t need the services of a direct‐access broker, your best bet is to select a discount broker.

Considering more than price

Your choice of brokers should be based on much more than who can offer you the cheapest price. Although price definitely is a factor in your selection of broker, it’s one of many factors you need to consider. The most important factors are the services that your broker offers and how effective and efficient the broker is in carrying out those promised services. Look for brokers that offer smart order‐routing capabilities, but steer clear of the ones that accept payment for order flow (see the earlier section “Types of orders supported”).

You may find a brokerage firm that provides all the bells and whistles at the cheapest price, but if its systems break down at a critical trading moment and you’re not able to implement your trades when you want to, those bells and whistles mean nothing, and not being able to rely on them can result in huge losses. Look for brokers that allow you to test‐drive a demo version of order‐entry systems. Also, if you want to trade using a mobile device, be sure your broker offers one that is dependable.

Doing a little research

If you expect to become an active and successful trader and want full access so you can trade electronically through the exchanges, you more than likely need to research direct‐access brokers. If, however, you believe that your volume of trades per month will be lower than 50, you may want to consider a discount broker that offers access to ECNs. Basically, your choice of brokers comes down to the types of services and accounts you need and which broker offers the best mix for what you want to do and pay.

Your first step is to make lists of your financial objectives, the types of trading you want to do, and the services you know you’re going to need. After committing those factors to memory, talk with other traders you know and be sure to find out what their experiences have been with various brokers.

You can also research and compare ratings of brokers on the Internet. Try these websites:

Kiplinger: Kiplinger picks the seven best online brokers for investors and explains why at http://www.kiplinger.com/slideshow/investing/T023-S003-best-online-brokers/index.html.
Barron’s: Barron’s publishes an annual survey of the best online brokers every March. Here is the one from 2016: http://www.barrons.com/articles/best-online-brokers-fidelity-wins-in-barrons-2016-survey-1458363203.
Stocks and Commodities: This magazine (www.traders.com) also periodically reviews brokers and trading platforms. Subscription is required.

After narrowing down your choices, check out the disciplinary histories of the brokerage firms you’re considering. You can easily do that by calling a toll‐free hotline operated by the Financial Industry Regulatory Authority (FINRA) at 800‐289‐9999, or checking its website at www.finra.org to find out what disciplinary actions (if any) have been taken by securities regulators or criminal authorities. On the front page of the FINRA website, you’ll see “Broker Check” at the top right of the page. You can use this to check the background of brokers. FINRA also has a Securities Helpline for Seniors you can call: 844‐574‐3577. You also need to call your state regulator to be sure the specific broker you’re thinking about working with is licensed to do business in your state. This information can be crucial. If you work with an unlicensed broker who goes out of business, you may not have any way of recovering any lost funds, even if an arbitrator or court rules in your favor.

Understanding how you’ll be paying

After conducting your initial research into brokerage firms and narrowing down your choices, be sure you understand how the brokerage firms are paid by

Reviewing each firm’s fee and commission schedule. The schedules should include the fees or charges you’re required to pay when opening the account and what you pay to maintain and close the account.
Finding out how your broker is compensated if you’re planning to work with a human being rather than trade online. Many brokers receive higher compensation when they sell their firm’s own products, so they may try to steer you toward them rather than another product that may be a better match for your trading objectives. Rarely are brokerage products good trading vehicles.

One other level of protection that you need to check on is the broker’s membership in the Securities Investor Protection Corporation (SIPC). Although SIPC membership won’t insure you against losses caused by market declines, the SIPC does give you some protection if your brokerage firm faces insolvency. You can find out more about the SIPC at www.sipc.org.

Getting to Know the Rules

After you pick your broker, you must be sure you know the trading rules. Although federal law mandates margin requirements, sets trade settlement rules, and bans free riding (nope, we’re not talking about horseback riding here), brokerage firms sometimes have even more stringent rules for their clients. We review the federal requirements here, but you need to check with your broker to find out any additional rules it imposes.

Rules for stock trading fall under the jurisdiction of the Federal Reserve, which specifies its stock trading regulations in Regulation T. Rules spelled out under Regulation T encompass margin accounts, broker‐dealer accounts, securities transactions, credit extended based on securities, and other factors related to securities markets. We don’t review all the specifics here, but instead we home in on three key areas that impact your trading choices — margin requirements, trade settlement, and free riding.

Margin requirements

The Federal Reserve’s Regulation T specifies how much you can borrow when you use a margin account to purchase new shares of stocks on margin. This initial margin requirement permits you to borrow up to 50 percent of the cost of the new shares. For example, if you open a new margin account with a $10,000 cash deposit, you can buy up to $20,000 worth of stock. After your $20,000 purchase, your account will have a cash balance of $0, an equity balance of $10,000, and a margin balance of $10,000. At this time, all your equity is committed to this trade, so you can’t enter any new positions unless you deposit additional funds.

If the stock price increases, your equity balance increases. If the stock price decreases, your equity balance decreases. In either case, your margin balance remains the same, $10,000. The only way to reduce the outstanding margin balance is to deposit extra cash into your account or sell the shares of stock.

When your stock price increases, your equity balance increases and you may use the increased equity as collateral to borrow additional money to buy additional shares of stocks. You may borrow up to the value of the increased equity balance, which increases your margin balance.

However, if your equity balance decreases, NASD rules (Rule 431 and Rule 2520, respectively) regulate the minimum equity position permitted in your account. Currently, the minimum is 25 percent of the total value of all margined securities if one is a pattern day trader (more about day trading in Chapter 18). Some brokers may require more.

For a pattern day trader, if the total value of the stock falls below $13,332, then the equity balance in your initial $10,000 portfolio will be less than 25 percent of the total remaining value. The math is simple: 25 percent of $13,332 is $3,333. Your cash balance is still $0, and your margin balance is still $10,000. Subtract $10,000 from $13,332 to determine your equity balance, which is $3,332. Your equity balance is less than 25 percent of your total account balance.

When this occurs, your broker will call and demand additional collateral to support the outstanding margin loan. This is a margin call. You may meet your margin‐call requirements by depositing more cash, or you may deposit fully paid, unmargined securities from another account. If you don’t deposit additional collateral, your broker is permitted to sell up to four times the amount of stock required to meet your margin call and may sell any of the stocks in your portfolio.

If you have more than a few positions, margin calculations become complex. It helps to think about it like this: When initiating a new position, you can never borrow more than half of the position’s value. To maintain sufficient collateral, your broker will insist that the value of your stocks be more than enough to cover the loan. Therefore, if your equity balance falls below 25 percent of the total portfolio value, your broker will ask for additional collateral in the form of a margin call.

As a trader, you should never satisfy a margin call. Instead, you should close the offending position(s). It’s possible that an extraordinary event may cause the value of your stocks to fall below the amount owed on your outstanding margin loan. If this happens, your broker will close your positions, but you must still repay the debt. Unlike a cash account, you can lose more than 100 percent of the money you deposit into a margin account.

Not all stocks can be bought on margin and neither can all stocks be used as collateral. If you want to trade on margin, be sure you understand the margin requirements imposed by your broker. Some brokerage firms require even stiffer requirements to maintain a margin account, especially if you trade volatile or lightly traded stocks.

If you trade any security in the same day in a margin account, be sure you understand the FINRA rules for day‐trading activity. Your broker or the FINRA will consider you a pattern day trader after you buy or sell any security on the same day in a margin account and execute four or more such trades during a five‐day business period (excluding Saturdays, Sundays, and holidays). If you’re pegged as a pattern day trader, you’re required to maintain $25,000 in your margin account, which can seriously impact your day trading and other trading activities.

Settling trades

When you place an order to buy a stock, you must settle that transaction in three business days. This settlement cycle is known as T + 3. The brokerage firm must receive your payment for any securities you buy no later than three days after the trade is executed. Today, many brokers require that the cash be in your account before placing the trade unless you have a margin account set up. If you’re selling a stock, it’s probably being held in your brokerage account and will be taken out of that account on the day of settlement. Options and government securities trade on a T + 1 settlement cycle, which means these transactions settle the next trading day.

Free riding

No, we’re not talking about hopping a train on the sly. Free riding in the stock‐trading world can get you in a bunch of trouble, so keep reading. Basically it means that you must pay for a stock before you can sell it, and because settling a stock transaction takes three days, that means, in theory, you can actually buy a stock and then place an order to sell it before the stock purchase actually settles. You can actually buy and sell a stock without any cash because of the lag time in settling the account.

This is a cash account problem. Although many swing and day traders actually turn around stock purchases and sales that quickly, they typically trade in a margin account and are able to sidestep the problem. Margin traders use the unsettled proceeds of a trade as collateral to borrow money until the trade is settled. Still, day traders and swing traders must have enough cash or buying power in their accounts to cover all purchases of stock.

Formally, this rule is found in Section 220 of Regulation T, which states that in a cash account a brokerage firm may buy a security on your behalf — or sell a security — if either of the following applies:

You have sufficient funds in the account.
The firm accepts in good faith your agreement to make a full‐cash payment for the security before you sell it.

If you do ever buy and sell a security before the settlement cycle (T + 3) is complete — or even on the same day — and without sufficient cash in your account, a brokerage firm can make what is called an intraday extension of credit (a loan), but it exposes the firm to increased risks — especially the risk that you may overextend your financial resources and may not be able to settle your trades. Most brokerage firms require active traders who buy and then sell securities within the settlement cycle to conduct those activities within a margin account.

If you take a free ride and haven’t made some type of credit arrangement with your broker, your broker is likely to freeze your account for 90 days. During that 90‐day period, the broker requires you to pay for any purchase on the date that you make the trade. In other words, you lose the option of settling your trades within three days. Some brokerage firms require you to have enough cash in your account to complete the transaction before you make the trade so you thus avoid even the risk of free riding.

We talk more about these rapid forms of trading (swing trading and day trading) in Chapters 17 and 18.