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Investing 101: Cash Liquidation Violations

I may not have mentioned in my previous publications, but my first introduction to investing was back in the year 2000.  I was a few years removed from college and knew very little about anything, yet alone investing.  I had opened up a brokerage account with an online trading company and was dabbling in buying securities.  I was terrible.  I was all over the map.  I bought penny stocks and stocks of companies that are now probably somewhere in Outer Mongolia, like The Football Network (TFNK) and Digital Mafia Entertainment.  It was a learning curve, indeed.  But, one other learning curve was understanding that there are rules when trading securities, and the cash liquidation violation rule is one of them.

Cash liquidation violations occur when you trade on a cash basis as opposed to trading on margin.  A cash liquidation violation occurs when you buy securities and cover the cost of that purchase through the sale of another security that you own; however, the security used to cover your purchase does not settle in time to cover the settlement date of the purchased security.

Sounds complicated?  Yes, that’s what my 20-something year-old brain thought as well.  But, let me give you an example to illustrate how you can incur a cash liquidation violation.

Example: Your account portfolio looks as follows:

Cash on hand: $5.00
C Stock: 100 shares.  Latest closing price $10.  Total value: $1000.
D Stock:   50 shares.  Latest closing price $50.  Total value: $2500.
E Stock:   20 shares.  Latest closing price $80.  Total value: $1600.

A stock (F stock) you’ve been wanting to purchase is red hot and the projections are that it’s going to be the next biggest stock in the history of stocks.  It’s trading at $50 per share.  You only have $5 dollars in cash in your account, but you decide to purchase the stock anyway.  At the same time you initiate the purchase of 20 shares of the stock (20 x $50 = $1000 total cost to you), you sell all of C stock for a total sum of $1000 to cover your purchase of F stock.  Unfortunately for you, the purchase settlement on F stock occurs before the sale settlement of C stock; thus, you won’t have the cash to technically close on time.  This will constitute a cash liquidation violation.

The moral of the story is… make sure you have enough cash on hand to cover any purchase that you may want to make.  If you don’t have the money in your account, and can’t put the money in the account in time to complete the purchase, just hold tight and wait for another red hot stock to come along.




 
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