Despite the nature of our highly technological society, a stock trade is not completed instantly. An investor may click the button and immediately receive a trade confirmation, but that is not the end of the transaction. Trade settlement, the time it takes for a stock transfer to be completed, is the trade date plus three trading days. Even in the world of online brokers, trades take three days to complete. Free riding in stock trading is when a broker's client purchases shares without paying for them and then sells the stock, making a profit.

Trade Settlement

When your stock trade executes, the settlement process begins. A stock "settles", meaning the stock trade is complete, three business days following the trade date. This is referred to as "T+3."

Free Riding

When an investor sells a stock on Monday, the funds from this sale do not belong to the investor until Thursday. Most brokerage firms, however, allow an investor to use these funds immediately to purchase another stock. But if a client then sells the stock before the settlement of the original sale, then the investor is making a profit using money that didn't belong to the investor.

Free Ride Violations

The Securities and Exchange Commission requires that stock purchases be paid for before they can be sold. Violations of this are considered a violation of credit provisions of the Federal Reserve Board. The penalty is a 90-day account restriction, which means an investor is relegated to cash-up-front trading only. If you don't have the cash, you don't get to buy the stock. Liquidating one security to cover a cash requirement on a security is also a violation and results in the same penalty.

Margin Account

Margin solves the free ride problem. Margin is a credit arrangement between the investor and the broker. This extension of credit fills in for the capital due while the trades settle.

Options Trading and Free Riding

Options are a contract to buy and sell an underlying product, in this case a stock, within a specified time for a specified price. Options do not settle in "T+3;" they settle the next day. As such, free riding is not a problem with options as it is with stock trading. Although risks exist with options trading that do not with stock trading, trading only in options will not result in a free ride violation.

Source:

Path To Investing: The settlement timetable

Investopedia: Free Rider Problem

Securities and Exchange Commission (SEC): Freeriding

More Information:

FINRA: Margin Information (including Margin Disclosure Statement)

SEC: Margin- Borrowing Money to Pay for Stocks