What Is A Good Faith Violation?

If you buy and sell equities using your cash account, one of the most common violations you need to know about is the good faith violation. 

To understand what a good faith violation is, we need to first understand the difference between settled and unsettled cash. But in short, a good faith violation occurs when you buy securities with funds that are available, but not settled, and then sell them before having settled funds in your account.

Settled vs unsettled cash

If you have a cash account with a brokerage, you’ll see both settled and unsettled cash in your account.

Settled cash refers to newly deposited funds, and funds that have settled from any sales of securities.

Unsettled cash refers to the proceeds from the sale of any securities in your account prior to the settlement date. You can use unsettled cash to open new positions, but closing those positions while your funds have not settled can result in a good faith violation.

How long does it take for my funds to settle?

When you buy or sell equities, the trade takes place immediately, but the settlement date takes two business days, according to industry standards. The settlement date is the day that the trade becomes final – the buyer makes the payment to the seller, and the seller transfers the securities to the buyer.

Options and government securities are settled the next business day, but stocks and bonds take two business days to settle. For example, if you sell equities on Monday, the funds will settle on Wednesday. If you sell equities on Friday, the funds will settle on Tuesday.

However, since the trade takes place immediately, you’ll have funds available from the sale that you can enter new positions with even though the funds are technically in an “unsettled” status.

How a good faith violation works (examples)

To better understand when a good faith violation is triggered, let’s go through some examples.

Example 1 (the most common example)

Let’s say that on Monday, you decide to sell $1,000 of Stock A to get cash available to trade. The same day, you use the money from the sale to buy $1,000 of Stock B. The next day, you sell Stock B. 

This would be a good faith violation because the cash from the Stock A sale does not settle until Wednesday (two business days later). You’re allowed to use unsettled funds to open new equity positions, but you cannot sell them until the funds used to purchase them become settled. In this example, you sold Stock B before the cash from Stock A settled.

Example 2 (settled funds become unsettled)

Let’s say that you have $5,000 in settled funds available to trade in your account. On Monday, you purchase $5,000 of Stock A. The same day, you sell your Stock A shares for $6,000, giving you a $1,000 profit.

This, itself, would not be a good faith violation since you completed the trade with settled funds in your account.

However, let’s say that you decide to re-enter the trade before the market closes that same day. You decide to hold onto your $1,000 profit from the earlier trade and buy just $5,000 worth of Stock A. The next day (Tuesday), you decide to sell your position.

This would be a good faith violation since you used unsettled funds from the initial sale on Monday. Even though you’re using the same $5,000 amount, because you executed an earlier trade, those funds now require two business days to settle. In this example, to avoid a good faith violation, you would have to wait until Wednesday to sell Stock A since you purchased them at market close on Monday.

Example 3 (mixing settled and unsettled funds)

Let’s say that you have $5,000 in settled cash in your account. On Monday, you decide to sell your position in Stock A for $5,000. Now you have $5,000 in settled cash plus $5,000 in unsettled cash from the sale of Stock A (which will take two business days to settle). Before the market closes that day, you decide to purchase 200 shares of Stock B for $10,000 total. The next day, you decide to sell your entire position of Stock B.

If you sell your entire position the next day, this would be considered a good faith violation since the $5,000 in funds from the sale of Stock A was never settled. However, if you only sell 100 shares of Stock B, it would not be considered a good faith violation since half of the shares were purchased with settled funds in your account.

Penalties for good faith violations

What happens when you receive a good faith violation? The first two times you receive a good faith violation, you’ll receive a warning in your account.

If you incur three good faith violations in a period of 12 months, your broker will restrict your account for 90 calendar days and you will only be able to buy stocks with settled cash in your account. This means you won’t be able to use the proceeds from a sale to make an additional purchase until that trade settles (after two business days).

How to avoid good faith violations

One way to avoid good faith violations is to only trade with settled funds in your account. You can check how much settled cash you have in your account by checking your balance that is “available for withdrawal.”

If you do decide to use unsettled funds to place a trade, make sure that you wait at least two business days for the funds to settle before selling.

Also read: What Is A Freeriding Violation?