What Is the 3-Day Rule in Stock Trading? (Stocks 3-Day Rule) (2024)

There are many rules of the stock market, both official and unofficial. One of the official rules of trading stocks is the three-day settlement rule. This rule is also referred to as the three-day trading rule, or T+3 (which means trade date plus three days). The three-day trading rule, created by the United States Security and Exchange Commission (SEC), is probably one of the most important rules anyone active in the stock market should know.

What is the three-day settlement rule?

One term you need to be familiar with to understand this rule is the word “settlement.” In the stock market, settlement is the transfer of securities from the seller to the buyer, and of payment for those securities from the buyer to the seller.

The three-day settlement rule states that a buyer, after purchasing a stock, must send payment to the brokerage firm within three business days after the trade date. The rule also requires the seller to provide the stocks within that time.

So, for example, if you bought stock from Business B, you have up to three business days to transfer money to Business B’s brokerage firm. In turn, Business B has up to three business days within which to transfer the stocks you’ve just purchased into your brokerage account.

Stock transactions are not instantaneous

No matter what it seems like when you buy and sell stocks in your online brokerage account, you don’t actually own a stock you purchase the same day your transaction shows as “filled.” In general, it will take three business days for a settlement to be reached. This can matter for things like dividends, for example, since you need to be an owner of record by a certain date to qualify for a scheduled dividend distribution.

Stock transactions take time because funds need to be properly cleared, and both the buyer and seller need to get appropriate documents together. Or, more often these days, their respective brokerages need to do so by punching the right buttons and getting the right confirmation messages.

So, if you buy or trade stocks on Monday, you’ll receive them, or the money for them in the case of a sale, by Thursday. If you purchase stocks on Friday, you should receive the settlement by the end of the business day on Wednesday. Those involved in finalizing your transaction will spend the days before the settlement is reached getting together documentation and making sure the money is good to go.

The rule applies to all securities, not just stocks

Why this rule is important

This rule was created by the U.S. Securities and Exchange Commission (SEC) in 1993. Before the change, buyers had five business days to settle a transaction. The SEC created T+3 to help prevent sizable losses and strengthen the financial market during times of stress.

The SEC intended the rule to limit the manipulation of stocks, keep a stable market, minimize the risk of financial complications, and make it easier for buyers to pay off their own purchases.

Arguably the most important reason the three-day rule is in place is to help keep a stable market. Having a limited amount of time to settle prevents financial complications such as defaults. If buyers had an unlimited amount of time to pay off their trades, they could end up spending more than they actually have. This is especially prevalent in plunging markets.

If this rule were not in place and a settlement took a long time, individuals could run out of money they initially had, or stock prices could change significantly while parties were still awaiting settlement and could not do any new transactions with the stocks or cash involved.

Violation of the three-day settlement rule

Violation of this rule could result in cash liquidation, free-riding violations, good-faith penalties, or certain restrictions being placed on the offender’s brokerage account.

But how is this rule violated? To understand this, you should be familiar with the term “unsettled cash.” This refers to the proceeds you are entitled to because of a sale that has not been settled yet. Though this cash is not yet in your brokerage account, brokerages will allow you to trade with it as though it were.

You can buy stocks with unsettled cash, but you cannot sell a stock for which your purchase has not settled, particularly a stock purchased with funds that had yet to settle when you made the buy. Doing so will result in a good-faith violation.

Example 1: Brian’s quick cash on Company X

Brian purchases stock from Company X on Tuesday. The purchase has not settled yet, but later that day the stocks for Company X begin to climb, so he decides to sell. Because this transaction involves sale of stocks that haven’t settled, this is a good-faith violation.

Buying and selling the same stocks over the course of the day is called day trading, or pattern day trading. A day trade is when you purchase and sell a stock on the same trading day. While day trading can be done legally, there are specific rules you must follow. If you’re interested in trading stocks professionally, the IRS has specific requirements you must comply with. Rapidly buying and selling shares requires investors to have a pattern day trader account. The most important pattern day trader rule is to be registered with the IRS, and the day trading account must have a minimum equity of $25,000.

Example 2: Hailey’s big gain on Business B

Another form of violation is if someone uses unsettled funds to purchase a stock then sells that stock. Here’s an example:

Hailey has no cash available for trading, so she sells a stock for Company X on Monday and should receive a settlement of $20,000 within three business days. But before she receives that $20,000, she purchases stock from Business B, since her brokerage allows her to trade with unsettled funds. As long as she then waits out the settlement of both her sale of Company X stock and purchase of Business B stock, no problem.

If she turns around and and tries to sell Business B stock for a quick profit, however, this is a violation, as she did not physically have the funds to purchase stock from Business B when she did so. She therefore sold a stock she never genuinely owned. You might be thinking this sounds like a neat trick and great way to earn money as a trader, but it’s actually a violation.

You’ll hear from your broker

You’ll know if you commit this violation when you receive a secure message warning you. If you commit three good-faith violations in one month, you will only be able to trade stock with settled money.

What about free riding?

Free riding is another violation made possible by the time gap between trade execution and trade settlement. If the net effect of your buying and selling is that the cost of stocks you purchased was paid for with the money earned from selling those same stocks, you’ve committed a free-ride violation. Free riding violates the Federal Reserve Board’s Regulation T, which governs brokers’ provision of credit to customers.

FAQ

Why do stocks take 3 days to settle?

Sellers are allowed three days to settle so that they can get together appropriate documentation and clear the funds that are to be used.

Why do you have to wait 3 days after selling stock?

The three-day wait is to ensure that the funds have been transferred to the appropriate brokerage firms. The three-day rule sets a maximum rather than minimum, so faster settlement is not impossible. Brokerages prefer to err on the side of safety, however, claiming the full three days they’re entitled to.

How many days after you sell a stock can you buy it back?

If you want to claim a loss on your initial sale for tax purposes, you need to wait 30 days to buy back the same stock. If that isn’t a concern, you may repurchase a sold stock as soon as you have funds available to do so.

How soon can I sell a stock after buying it?

You can sell a stock as soon as your purchase of it has settled.

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