What Is a Good Faith Violation? How to Avoid It

In the world of trading, navigating the complex rules of account management is crucial for every investor. One misstep that traders—especially those new to financial markets—often stumble upon is the good faith violation. Understanding this concept is essential to managing your trades effectively and maintaining a compliant and profitable trading strategy.

Read this article to learn how to manage your trades to avoid good faith violations, ensuring compliance and profitability in your trading!

I’ll answer the following questions:

• What is a good faith violation?
• How can I avoid a good faith violation?
• What are the penalties for a good faith violation?
• Who is responsible for a good faith violation?
• What happens if I get multiple good faith violations?
• What is trade settlement?
• Is a good faith violation illegal?
• How do mutual funds purchases and sales relate to good faith violations?

Let’s get to the content!

What Is a Good Faith Violation?

A good faith violation occurs when a trader sells a security bought with unsettled funds, and then does not hold onto the security long enough for the purchase to be fully paid for with either deposited or settled funds. Essentially, it’s about the timing of the cash flow in your brokerage account, an area where many new traders inadvertently step wrong.

Good faith violations are closely tied to the broader framework of pattern day trading rules, which govern the number of trades one can make within certain periods and the capital required in the trader’s account. These rules are designed to protect both the trader and the market from excessive risk. For traders, understanding these rules is essential to navigate day trading without facing penalties. To get a comprehensive overview of these regulations and how to manage your trading activities within them, explore this detailed explanation of pattern day trading rules.

Reasons for Good Faith Violations

Good faith violations typically happen in cash accounts where traders are using the proceeds from a recent sale to fund new purchases. The key issue arises when the proceeds used haven’t yet been settled—usually taking two business days from the trade date in the U.S. My approach always emphasizes the importance of understanding the settlement cycle to avoid these pitfalls, which can be a little complex for newcomers but are vital for compliant trading activities.

Penalty for a Good Faith Violation

Penalties for good faith violations can vary depending on the brokerage but generally include warnings, restrictions on trading, or even the freezing of your account for serious or repeated offenses. In my early trading days, witnessing a colleague face account restrictions was a real eye-opener to the seriousness of these rules and the need for diligent account management.

Examples of Good Faith Violations

An example of a good faith violation might involve buying ABC stock on Monday, selling it on Tuesday, and using those unsettled proceeds to buy XYZ stock on the same day—before the sale of ABC stock has settled. These types of transactions can lead to violations if not managed properly, emphasizing the need for traders to fully understand trade and settlement dates.

Who Is Responsible for a Good Faith Violation?

Responsibility for a good faith violation often falls not just on the individual trader but also on the brokerage firm providing the trading services. Traders are expected to manage their trades within the rules set by the brokerage, which means understanding when funds will settle and not using unsettled funds to engage in further trading. Brokerage firms, on the other hand, must ensure their customers are well informed about the settlement period and the consequences of violating these rules. 

In my years of providing investment advice, I’ve always stressed the importance of education in trading practices—both the trader and the brokerage share the duty to prevent violations. Regulatory bodies also play a crucial role, enforcing the rules and ensuring that both brokers and traders adhere to ethical trading practices.

Brokerage Firms and Customers

Both brokerage firms and customers have roles to play in avoiding good faith violations. Brokerages are responsible for educating their clients about the rules of trading within and across accounts and must enforce regulations to prevent such violations. As a trader and instructor, I stress the importance of traders understanding their brokerage account rules, which can differ slightly between firms, to navigate trades safely.

Regulators and Exchanges

Regulators and exchanges set the rules that define good faith violations, ensuring a fair and orderly market. They monitor transactions and can impose sanctions on brokerages and traders who fail to comply with these rules. Understanding the role of these entities helps traders appreciate why certain regulations are in place—primarily to protect the market and its participants.

Market Participants and Institutions

Market participants and financial institutions must also adhere to these trading rules. Large investors and funds often have sophisticated systems and controls to prevent violations, something individual traders can learn from and emulate in their own trading practices.

Understanding Margin Account Vs. Cash Account

The main difference between a margin account and a cash account lies in how securities are purchased. Margin accounts allow traders to borrow money from a brokerage to buy securities, which can amplify both the potential gains and losses. A cash account requires traders to fully pay for securities with available funds at the time of purchase. My experience shows that choosing the right type of account is crucial, depending on your trading style and risk tolerance.

Navigating the financial requirements for margin accounts can be daunting, especially with the $25,000 minimum equity requirement for pattern day trading. You need to be prepared — even if you have an easy-access broker like Robinhood. For detailed strategies on how to day trade on Robinhood without $25k, this guide provides practical tips and insights to maximize your trading potential without the hefty upfront investment.

What Is Settled Cash?

Settled cash in a trading account refers to funds that have been cleared and are readily available for new investments without any restriction. This clearing process typically takes two days after a trade is executed (known as T+2) for stocks, with variations depending on the type of securities involved such as options, futures, or commodities. Starting May 28, 2024, most securities transactions will switch to T+1, settling on the next business day following their transaction date.

Understanding the distinction between settled and unsettled cash is crucial for managing cash flow effectively in trading activities, especially to avoid good faith violations. My guidance on finance and investment consistently highlights the need to monitor settlement times closely to maintain liquidity and ensure trading flexibility without inadvertently committing a violation.

Settled Cash Vs. Cash Available to Trade

Settled cash refers to funds that have been cleared and are available to use without any restrictions on transactions. In contrast, cash available to trade may include unsettled funds from recent sales that cannot yet be used to buy other securities without risking a violation. The distinction is critical in planning trade activities, as using unsettled cash can lead to good faith violations.

How to Avoid a Good Faith Violation

Avoiding a good faith violation is fundamentally about understanding and respecting the settlement process for trades. Traders should ensure that they use only settled funds for new purchases unless trading in a margin account that covers the cost of purchases immediately. Monitoring account activity closely at market close to ensure all trades are covered by either existing settled cash or proper financing is crucial. 

My advice, based on extensive experience in the finance and banking sectors, also includes keeping a meticulous record of all trading activities. This record-keeping can help track the settlement of each transaction and prevent the use of unsettled funds inadvertently. Traders should seek comprehensive investment advice from trusted sources, which can offer reminders and automated updates concerning settlement dates and available balances.

Understand the Risks Involved with Trading in Margin Accounts

Trading on margin amplifies the risks, as borrowing funds increases the potential for losses. Understanding these risks is crucial to managing your trades effectively and avoiding violations. I always advise new traders to start with virtual trading or small positions to familiarize themselves with these dynamics before fully committing capital.

Monitor Maintenance Margin Requirements Closely

Maintenance margin—the minimum portfolio value you must maintain—can fluctuate with market movements. Regular monitoring helps ensure you don’t fall below this threshold, which could prompt a margin call or forced liquidation of securities, potentially leading to unintended good faith violations.

Options trading is a whole different ball game — especially Level 3 options! This advanced level of trading allows for the execution of complex strategies that can leverage market movements more substantially than simple stock trades. However, it requires a thorough understanding of options and the risks involved, as well as strict adherence to margin requirements to avoid potential violations. For those interested in advancing their options skills, here is a guide to Level 3 options trading that covers essential strategies and compliance tips.

Adhere to 90-Day Restriction on Cash Liquidations

If you’re flagged for multiple good faith violations, you may face a 90-day restriction on purchasing securities with unsettled funds. Sticking to this rule is essential to maintain your trading privileges and prevent further restrictions.

Follow Rules on Mutual Funds Purchases & Sales

Mutual funds have specific settlement rules that differ from stocks and bonds. Understanding and adhering to these rules can help you avoid accidental violations when trading these types of securities.

What Happens When You Incur a Good Faith Violation?

Incurring a good faith violation can lead to several consequences, including restrictions on your trading activities. It’s essential to address these violations promptly with your brokerage to understand the implications and corrective steps.

Key Takeaways

• Good faith violations stem from the misuse of unsettled funds in cash accounts.
• Educating yourself on the settlement process and account rules can prevent these violations.
• Choosing the right account type for your trading style and closely monitoring your trades are key to compliance and success in the markets.

There are a ton of ways to build day trading careers… But all of them start with the basics.

Before you even think about becoming profitable, you’ll need to build a solid foundation. That’s what I help my students do every day — scanning the market, outlining trading plans, and answering any questions that come up.

You can check out the NO-COST webinar here for a closer look at how profitable traders go about preparing for the trading day!

Do you trade using a margin or cash account? Let me know in the comments!

Frequently Asked Questions

What Happens If I Get Multiple GFVs?

Multiple GFVs can result in stricter penalties, such as being restricted to trading only with settled funds. This can limit your trading flexibility and should be avoided through careful trade planning and knowledge of settlement times.

What Is Trade Settlement?

Trade settlement refers to the official transfer of securities to the buyer’s account and cash to the seller’s account. It typically takes place two business days after the trade date (T+2) for most securities.

Starting May 28, 2024, most securities transactions will switch to T+1, settling on the next business day following their transaction date.

Is Good Faith Violation Illegal?

While not illegal, good faith violations are breaches of brokerage regulations and can lead to severe penalties, including account restrictions. Understanding and adhering to trading rules is crucial for maintaining good standing with your brokerage and ensuring continued trading access.

What Is a Good Faith Violation and How Does It Affect Trading?

A good faith violation occurs when a trader sells securities bought with unsettled funds and then does not hold onto those funds until the settlement of the sale. It primarily concerns shares and currency trades where the payment is made using the proceeds of a recently sold asset before these funds have settled. This is closely related to freeriding and cash liquidation violations, where traders misuse the timing of funds settlement to their advantage. Traders must manage their transactions carefully to avoid these violations, understanding the amount and timing of income and results reported to ensure compliance with trading regulations.

How Can Traders Manage Cash Liquidation and Freeriding Violations?

Managing cash liquidation and freeriding violations involves understanding the regulations around the settlement of trades. A cash liquidation violation occurs when a trader buys securities with unsettled funds and then sells them before funding the initial purchase with settled cash, similar to a freeriding violation but with a focus on the sequence of trades. To avoid these issues, traders should track their payment schedules, the amount of capital involved, and the tax implications of their trades. Proper planning and adherence to settlement rules are essential to prevent penalties and maintain good standing in trading environments.

Why Is Information About Trading Rights and Member Responsibilities Important?

Information about trading rights and member responsibilities is crucial to navigating the legal landscape of trading on platforms that handle products like shares and currency. Members of trading platforms must understand their rights to fair treatment and transparent information, as well as their responsibilities to comply with trading laws and regulations, including those pertaining to good faith violations. Clear knowledge of these rights and duties helps traders avoid legal pitfalls and manage their investments more effectively.