What are unsettled funds?

Before the internet enabled money to be instantly transferable, owning a stock meant possessing a physical stock certificate, and trading a security required several days to complete. That’s why the Securities and Exchange Commission (SEC) created settlement periods — to allow time for buyers and sellers to physically exchange their respective halves of the trade.

While it no longer takes days to transfer money, settlement periods are still a factor of securities trading, creating the concept of unsettled funds.

The proceeds created by selling a security are considered unsettled funds (a.k.a. unsettled cash) from the time you place a trade order until the completion of the settlement period (more on settlement periods momentarily). Because stocks have a two-business-day settlement period, proceeds generated by selling stock in a cash account are considered unsettled for the two-day period following the trade date, since the sale is not technically completed.

The settlement period is the time from the date on which the trade is executed on the market to the date on which the trade is finalized.

Under Federal Reserve Board Regulation T, securities transactions in a cash account must be paid for in full. By the end of the settlement period, a buyer must have paid for the trade completely and the seller must have delivered the security.

As money transfers can now be completed instantaneously, in 2017, the United States adopted the two-day settlement period in lieu of the then-existing three-day settlement period in effect since 1993. More specifically, this means stock trades settle two business days following the trade date (T+2). For example, if a stock is sold on Monday, the trade is settled on Wednesday. ETFs follow the same rules as stocks and have a T+2 settlement period.

Other types of securities have different settlement periods. For instance, option trades settle one business day following the trade date (T+1). Most mutual funds’ settlement periods currently are T+2, but some may vary between T+1 and T+3.

While your funds remain unsettled until the completion of the settlement period, you can use the proceeds from a sale immediately to make another purchase in a cash account, as long as the proceeds do not result from a day trade. (Proceeds from a day trade can only be used on the following trading day.)

Depending on your brokerage, the cash you can use to buy securities may be referred to as your “cash buying power” or “cash available to trade.” It combines settled cash and unsettled proceeds.

If you purchase a security in a cash account with either insufficient funds or unsettled funds, you must hold that security until either you pay for it fully with a new deposit, or the settlement date of the trade that generated the funds for the purchase. (On the other hand, if you purchase a security with settled funds in your cash account, you may sell that security at any time without restriction.)

When you use unsettled sale proceeds to purchase another security, you agree in good faith to hold the new purchase until the funds from the original sale settle.

For example: Consider you sold stock XYZ for $5,000 on Monday. Then, on Tuesday, you used the unsettled funds to purchase stock ABC for $4,000. You must hold on to stock ABC until the proceeds from your stock XYZ sale settle on Wednesday.

Read our Unsettled Proceeds Sales disclosure here.

If you trade using unsettled funds in good faith, you should be aware of potential settlement violations.

Cash liquidation violation: A cash liquidation violation occurs when you don’t have sufficient cash to cover the cost of a trade. For example, consider you have $1,000 of settled cash in your account, and you own $2,000 of stock ABC. On Monday, you purchase stock XYZ for $2,000, and on Tuesday you sell $1,000 of stock ABC. The settlement date for your purchase of stock XYZ is Wednesday (T+2), meaning you must pay for it in full by then. However, the settlement date for your sale of stock ABC isn’t until Thursday, meaning the sale was not finalized in time to pay for the purchase of stock XYZ.

Freeride violation: A freeride violation occurs when you purchase a security in a cash account with insufficient funds and sell the same security before paying for it in full by the settlement date.

Good faith violation: While unsettled funds may be used to purchase a security in good faith, you cannot sell any part of the newly purchased security before the funds have settled. Doing so is a good faith violation.

Keep in mind: The rules for trading in a cash account are different from a margin account. (In order to trade in a margin account , you’ll need to apply for a margin account and maintain a minimum account balance of $2,000.) When purchasing securities in a cash account, remember that stocks have a two-business-day settlement period from trade date to settlement date. During that time, proceeds from a sale are considered unsettled funds.

The key is knowing if you bought the stock using settled or unsettled cash. If you bought the stock (or other type of security) using settled cash, you can sell it at any time. But if you buy a stock with unsettled funds, selling it before the funds used to purchase have settled is a violation of Regulation T (a.k.a. a good faith violation, mentioned above). If you commit a violation, you’ll be penalized with a 90-day restriction on your account.

While stock trades don’t require the in-person hand off of cash and certificates they did in the past, it’s important to remember that settlement periods still remain. Understanding unsettled funds and how you can and cannot use them will help you keep your trades in-line.

Contact us at Ally Invest  if you have questions regarding unsettled funds in your cash account.