Trading in IRA accounts, and avoiding “free riding”


Friday, June 7th, 2013 | Vance Harwood

As much as possible I try to trade in my IRA accounts—in order to defer taxes of course. It is a bit counter intuitive to be doing more speculative activities in a retirement account, but this approach supports my goals:

  • Achieving good returns
  • With reasonable risks
  • While compounding growth

If your money is in Roth accounts, all the better, but most people interested in trading in their IRAs are restricted to traditional IRAs.

There are restrictions on what trades you can do in an IRA account.  For example you can’t short a stock in an IRA account, but option restrictions have eased some over the years,  and market innovations like short ETFs (e.g., SH, SDS) have effectively bypassed some of the more onerous restrictions.    Brokers vary in what they allow in IRA accounts, so pays to ask around.   Fidelity for example allows me to do some types of equity option spreads, while Schwab does not.   Covered calls and protective puts on long positions are broadly available within IRAs.

For a more general treatment on trading in IRAs see  “Top 15 Questions About Trading in IRAs.”  The rest of this post will deal with free riding and how to avoid it.

Generally your broker’s software will block you if you try to do something that is not allowed in an IRA account, but there is at least one area that is particularly tricky—avoiding  “free riding”, formally a SEC Regulation T violation .     Free riding occurs when you enter and exit a position using funds from a previous transaction without waiting the required settlement period for the previous sale—3 days for stocks.   Three days seems like an eternity, but the settlement rules pre-date computers, and brokers don’t mind holding your money three days after you sell a stock.  They aren’t lobbying to change the rules.

An example of free riding, would be if in a cash (non-margin) or IRA account you use all the cash settled money in the account to buy stock, sell all the stock, buy stock again, and then sell it again before the 3 day settlement period has elapsed for the initial sale.

Typically your broker’s software will warn you if you are getting close to free riding (e.g., with a quick sell, buy sequence), but the warnings are usually cryptic, and easy to miss along with all the other info associated with a trade.   If in doubt it is always a good idea to call your broker.

The free riding rule is intended to prevent people from speculating without actually putting up any money.  If the out-in-out scenario above was allowed, the investor would never have to give their broker any money—because they would be out of all their positions before the 3 day settlement period was over—effectively selling a stock before they have paid for it.   Normally free riding can be avoided by trading in a margin account.  Don’t hold me to the actual details, but I suspect the broker collects interest during fast  in/out trading in a margin account.  But IRA accounts aren’t generally set up as margin accounts, because loans are not allowed in them—so you have to be careful to avoid free-trading.

Once you understand the intent, it isn’t too hard to avoid the day to day trading restrictions, but what gets a little tricker is the possibility of events outside your direct control—e.g., stop loss orders or  option assignments.   Options with American style exercise policies (most equity options), can be assigned by the option owner, at expiration, or any time before.   So if you have done a quick sell, buy transaction and plan to sit tight until the settlement period is over (which I believe is totally ok under the free riding rules),  you should be very careful if your position includes short options (e.g. covered calls) or stop loss orders.    In-the-money options are certain to be called at expiration, and if your position is going ex-dividend your in-the-money calls might be assigned the night before the ex-dividend date.

If you do violate the free-trading rules it isn’t the end of the world.   Initial penalties will probably include not allowing you to buy with unsettled funds, but I’m sure repeated offenses are a bad idea.

I am often short call options, so I generally only use funds that are marked “settled cash”, or “cash available to withdraw” —that way I have no worries about free riding.

 

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Friday, June 7th, 2013 | Vance Harwood
  • InvestorInvested

    Free riding rules are just part of the institutional rubric steup to frustrate the aavregae person from doing what Wall Street does day in and day out. There is absolutely no reason for the rule in this day and age because transactions can be settled in seconds. Ironically, if it is a margined account it is O.K., which is precisely contrary to good policy, which should encourage a balanced cash account for the average investor. This is basically an interest float ripoff.

  • InvestorInvested

    Free riding rules are just part of the institutional rubric steup to frustrate the average person from doing what Wall Street does day in and day out. There is absolutely no reason for the rule in this day and age because transactions can be settled in seconds. Ironically, if it is a margined account it is O.K., which is precisely contrary to good policy, which should encourage a balanced cash account for the average investor. This is basically an interest float ripoff.

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  • http://www.learn-stock-options-trading.com/ Travis

    I’m one of those idiots who ignored the whole “trade in your IRA account” until I had to pay taxes on my profits one year…I never made that mistake again.

    Thanks for the post. More people need to hear this advice.

  • J.

    I believe T+3 is based on the BUY settling not the SELL. The reason it is not the Sell is because the subsequent buy won’t settle for T+3 as well… so the SELL and then BUY isn’t the problem… it is the intintial BUY being unsettled because you are selling something you don’t yet have and then turning around and using the proceeds of an unsettled BUY to trade with.

  • Vance3h

    Hi J.

    I agree that the T+3 is based on the buy date if there are not settled funds available in the account at the time of the initial purchase. However in an IRA I would think an initial purchase, where you have to deliver cash to your broker is a relatively rare situation given the restrictions on contributions to IRAs. I think it is more likely that people run into problems with quick sell-buy-sell sequences, where settled funds are in the account for the initial purchase, but a quick sale / buy sequence runs a risk of good faith violation / free-riding if the 2nd purchase is sold again before the 3 days it takes for the proceeds from the 1st sale to become settled funds. My post is not clear on this. Thanks for your comment, I’ll rework my post soon to incorporate your scenario and hopefully make it clearer overall. Not easy with this subject..

    – Vance

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  • Adam

    Interactive Brokers, possibly TD Ameritrade, and possibly a few other brokerages offer “limited margin” retirement accounts (including Roth 401k’s in the case of TD Ameritrade, if I understand correctly).  These are essentially non-margin accounts, but the important difference is that you can sell securities even if the money used to buy them is still in “unsettled cash” without a “good faith violation.”

    For example, if you learn that a stock is briefly going to rise in price in a few hours and then drop but you don’t have the stock in your retirment account to take advantage of this, you could sell some of your more stable stocks in the retirement account, buy the briefly hot stock, and then sell the briefly hot stock when the price has spiked.  The “limited margin” feature makes a difference in that final sale.  Without the “limited margin” capability, that final sell would incur a regulation T good faith violation (in violation of the “T+3″ rule).  If you have more than 3 GFV’s in a year, you could be restricted to buying only with settled cash for 90 days.  At Fidelity, at least, I am told that that restriction applies to all accounts held by the same owner.

  • vance3h

    Hi Adam, Thanks for the info. I could see this capability might also be useful if an unexpected transaction occurred (e.g., option assignment).

    – Vance

  • FidelitySucks

    Having the “limited margin” IRA is the reason i moved to TD Ameritrade. Having to worry about incurring agood faith violation is ridiculous, there’s no need for it other than making it harder for you to trade. All the user is looking for is the buy/sell stocks anytime he wants with the money he actually has in the account.

    Good faith violations and the T+3 rule should die a horrible death. I made sure Fidelity was aware that this was the reason i was pulling my money from them.

  • SmartInvestor

    Interactive Brokers and TD offer Marginable IRAs that let you get past this silly T+3 rule.

  • Positionater

    New FINRA 4210(f)(2)(N)(ii) p 153 says no index option calendar/diagonals in cash accounts (IRA) since they aren’t considered covered anymore. Even though you can always sell the back month, it can’t be “exercised” until it’s expiration. So if the poop hits the fan (black swan event), you need to cover it all with cash. ETFs work, but at substantial commission uptick (10x or so due to multiplier). Makes vega trumping tough in IRAs (adding time based spreads to verticals to hedge), which is tough in todays low VIX environment.

  • http://www.sixfigureinvesting.com/blog Vance Harwood

    Hi Positionater, Thanks for the update / reference. The restriction seems a little ridiculous, but with European exercise the option prices in an extreme environment could get out of whack.

    – Vance