Brokerage Perspective on Freeriding vs. Good Faith Funding Violations

Today I will discuss freeriding and good faith funding violations.

I contacted TD Ameritrade (TDA) about the specific example described at the end of my last post and they said it would not be an issue. I would receive an e-mail over the weekend telling me the shares had been assigned and that I need to take immediate action to cover the position. I am clear provided I do this near the open on Monday morning. If I delay, then TDA has the right to apply discretion on a case-by-case basis. In so doing, they will make every effort to do what’s best for my account value and the brokerage.

Before I explain the brokerage perspective, I want to reference the SEC website with regard to “freeriding.” According to the SEC website, I am allowed to use unsettled funds to make a subsequent transaction in a cash account but I must wait until the initial funds settle before offsetting the subsequent transaction. Failure to do so is called freeriding. Covering the short with $191,000 of unsettled funds (recall that the account previously contained $100,000) is okay but continuing to trade with those funds before the $291,000 settles is not.

Freeriding is a violation of the Federal Reserve Board’s Regulation T, and brokers/dealers must suspend or restrict cash accounts for 90 days as a penalty. This shouldn’t be an issue with margin accounts because the funds may be borrowed until settlement clears. If a cash account is restricted, then securities may only be purchased using settled funds. Equity (option) transactions are settled two (one) business day after the transaction date.

TD Ameritrade makes a distinction between freeriding and a good faith violation. Here is an example of the latter:

• On Monday, I hold ABC stock.
• On Tuesday I sell ABC stock, which will settle on Thursday (two business days later).
• On Wednesday morning, I buy XYZ stock.
• On Wednesday afternoon, I sell XYZ stock for a profit.

My Wednesday morning purchase was done on good faith that the sale of ABC would settle thereby making the funds available. I am in violation because I did not wait for the ABC settlement before selling XYZ stock, which means I never fully paid for XYZ. For this, I would receive an e-mail explaining the violation. If I am in violation three times within 12 months, then my account will be restricted to using only settled funds for 90 days.

TDA regards freeriding as a situation where funds are never in the account. An example of this could involve a failed incoming ACH transfer. While ACH transactions may take up to two business days to settle, TDA makes the funds available immediately for marginable stock above $5 on a listed exchange (not options). Suppose that on the day I open a new account with a $25,000 ACH transfer, I buy $25,000 of QRS stock and sell later that afternoon for a 100% profit. If the $25,000 deposit never goes through, then I have committed a freeriding violation and profits will be seized.

In speaking with TDA, my confusion between freeriding and a good faith violation may be explained by limited margin they grant to retirement accounts. Margin is pledging securities as collateral for a brokerage loan. Accounts given tax-deferred (traditional IRA) or tax-exempt (Roth IRA) status are prohibited from accepting such loans and may lose their favorable tax status for doing so. The limited margin applied here is the ability to use unsettled funds for subsequent trades—not to provide leverage, but rather to prevent trip-ups resulting from specific, temporal oversights.

Potential Tax Implications and Settlement Issues

Before I go into the second part of this investment approach, I want to address tax considerations and discuss some details about option assignment and settlement.

Please keep in mind the following disclaimer: I am not a tax professional and while the following holds true for me, your personal situation may differ.

If a long-term long call is substituted for the married put, then favorable tax treatment may be available if done with cash-settled SPX options rather than SPY. The underlying index (SPX) cannot be purchased, so the synthetic equivalent must be used in lieu of the married put. I have read—but not confirmed—that some brokerages allow for cross-margining between SPY shares and SPX options. I wonder if said brokerages would cross-margin with other S&P 500 ETFs as well (e.g. IVV)?

Because I am not a tax specialist, I will quickly go over tax implications even though this deserves much more space. Options held longer than one year qualify for long-term capital gains (LTCG) treatment. The SPY ETF qualifies for LTCG treatment if held for more than one year (with the goal being to presumably hold and defer tax payment indefinitely). As suggested above, “favorable” means profit/loss on SPX options gets split into 60% LTCG and 40% short-term capital gains regardless of holding period. Holding for longer than one year would be ill-advised because I would still have to pay 40% short-term capital gains taxes on what would otherwise qualify as 100% LTCG (e.g. SPY options).

Assignment of shares can be a problem for retirement accounts. Consider what happens if I sell 10 Jul 300/290 bear call spreads on SPY for $3.00 each in my $100,000 IRA account. The most I can lose appears to be 10 * $100/contract * 10 contracts = $10,000, which is 10% of the initial account value. At expiration, suppose SPY trades at $291. I will be assigned on the short 290 calls forcing me to sell 1000 shares for $290,000. Because short positions are not allowed in IRAs, the position must be covered immediately. At Monday’s open, suppose I buy to cover for $291/share (assuming no price change from the close, which is not very realistic). I lose $1,000 of the $3,000 initially credited at trade inception on the assignment/cover, bank the profit, and move on.

“Not so fast, my friend.”

Being assigned on the short 290 calls brings 290 * $100/contract * 10 contracts = $290,000 into my account, but trades are not settled until two business days after execution. Being an IRA account, I must cover the short immediately with $291,000, which I do not have currently available since the sale has not yet settled.

Is this a problem?

I will discuss next time.

Not Exactly a Cash Replacement Strategy (Part 2)

Today I continue study of what I am calling not exactly a cash-replacement strategy: the first component of a new (to me) investing approach.

This component is not exactly a cash-replacement strategy because it carries more risk than cash, which can really only lose to inflation. Backtesting will help to put context around “more risk,” but max loss being realized over a string of consecutive years would severely damage core equity. If I deem the potential for adverse performance to be limited, then I may choose to use this as a cash replacement.

I can think of a few potential variants with the first being leveraging up leftover cash. In the example I gave last time, on a $247 investment my max risk is less than $20 (not counting dividends) for the year. Why not double to 200 shares and buy two puts? My max risk would then be less than $40, which is just under 17%, and my potential profit (unlimited) would increase twice as fast. The downside is that losses start to accrue with anything less than a $20 (per 100 shares) gain by expiration.* I am interested to look at the historical distribution of returns to get an idea of the probabilities.

A second potential variant to the married put cash replacement is resetting the long put ATM to lock in gains once the market rallies X%. This would cost more money although if months have passed, then I can seize the opportunity to roll the put out in time, which would eventually have to be done anyway.* I think backtesting this entire approach will have to be some sort of horizontal (by date) summation of components. For this variant, separate backtesting of the put involves exit after an X% gain in the underlying (for a loss) or exit with Y months to expiration (for a gain or loss): whichever comes first.

A third variant to the married put cash replacement is to buy a put debit spread for limited downside protection if VIX > Z. This would limit cost of insurance at the risk of losing more overall if the market decline continues thereby forcing an early exit (e.g. at the long strike?). From a backtesting perspective, this would be challenging because not only do I have to backtest across a range of Z, I should also backtest across a range of vertical spread widths (or debit spread prices).

A married put is synthetically equivalent to a long call, which suggests as a fourth variant purchase of a long-dated ATM call alone. With one leg instead of two, this might be an easier trade (unless I were to hold SPY shares and only move around the long put, which would nullify the simplicity advantage). Done this way, I should invest the remainder in T-bills or some other cash proxy unless I intend to leverage up as described three paragraphs above.

I will continue next time.

* — My intent will not be to hold to expiration due to accelerated time decay in the final months.

Not Exactly a Cash Replacement Strategy (Part 1)

Today I will talk about the first component to a hedged approach to option trading.

A cash replacement is relatively safe. Cash is savings accounts, money market accounts, certificates of deposit, FDIC insured, etc. Cash suffers from inflation risk: it will be devalued over time if the interest rate (currently near zero) is less than the rate of inflation, which is generally not the case (see below). A cash replacement will not be government insured, but it should have comparable risk in terms of how much it may lose in any given year.

The first component in the proposed hedged portfolio approach is a married put. This is a long-term ATM put and 100 shares of underlying stock. The maximum potential loss is the total cost of the put. If the market is lower at expiration, then the loss incurred by the shares is offset by intrinsic value of the long put. If the market is higher at expiration, then the cost of the put subtracts from gains in the shares. The risk graph is shown below:

Before I can assess a potential cash replacement, I need to understand the historical annualized return on cash. According to Portfolio Visualizer, using Vanguard Short-Term Treasury Fund Investor Shares (VFISX) as a proxy for cash reveals an average CAGR of 3.75% (1.48% after inflation) from Jan 1992 through Mar 2021. The range is -0.57% to 12.11% with a standard deviation of 1.91%.*

Next, I need to run a backtest to get a comparable performance distribution for the married put. The shares will benefit from the annual dividend to discount the put cost, which is ~2% in recent decades.

Always implied when we see benchmark returns is that 100% of the account is invested. Few people really do that. The long-time rule of thumb, which I am not advocating, has been to invest in equities a percentage equal to “100 minus your age.” In a pinch, a “conservative” asset allocation often preached is 60% stocks + 40% bonds. Either way, whatever the equities return in any given period must be diluted accordingly to calculate total portfolio return.

If I believe the married put to be sufficiently safe, then I can use it as a repository for cash in the account and avoid deleveraging the portfolio as just described. Committing 100% of my investible assets to an approach like this would immediately give me a 4% (or more) advantage per 10% CAGR according to the traditional approaches mentioned above. That’s a huge head start.

While I will be interested to see the overall return of the married put, in theory the total cost seems more reasonable in periods of low volatility than high. In the latter portion of 2017 with SPY around $247, a 2-year ATM put could be purchased for about $20. The dividend yield was about 2% so the annual cost of this insurance was about 2.1% (rounding up).

Would I risk putting my remaining assets in a vehicle that could lose no more than 2.1%? Inflation has averaged 1.2% over the last 12 months, which means cash has returned roughly -1.0%. Losing 1% is not much better than losing 2.1%, perhaps, although with implied volatility currently higher maybe the potential loss is also higher—either way, if my answer is ultimately yes then this could adequately serve the purpose of cash replacement.

I will continue next time.

* — As an aside, correlation to US equities is -0.19.