What Is Cash Trading?
Cash trading requires that all transactions be paid for by funds available in the account at the time of settlement. It is the buying or selling of securities by providing the capital needed to fund the transaction without relying on the use of margin.
Cash trading can only be carried out if the brokerage account has sufficient cash needed to complete a transaction.
- Cash trading involves buying or selling securities using cash funds held in a brokerage or clearing account.
- Cash trading does not involve the use of margin, which means cash trades tend to be safer for brokers than margin trading accounts.
- The downside of cash trading is that there is less upside potential due to the lack of leverage.
Understanding Cash Trading
Cash trading is simply the buying and selling of securities using cash on hand rather than borrowed capital or margin. Most brokers offer cash trading accounts as a default account option. Since there’s no margin provided, these accounts are much simpler to open and maintain than margin accounts.
The lack of margin makes these accounts inappropriate for most active traders. However, long-term investors may use these accounts as a standard option since they don’t typically buy securities on margin or require rapid trading settlements.
The settlement date is the day when the transaction is deemed to be consummated and the buyer has to complete full payment. Stock trades placed in cash accounts used to require up to three business days for settlement but that was amended in 2017 to two days. Market terminology for settlement is T+2—trade date plus two business days.
The most common types of potential violations that an investor should be aware of if they are cash trading are:
- Cash liquidation violation: One cannot buy if there is insufficient cash to cover that trade. For example, a cash trading account has $5,000 available cash and $20,000 tied up in ABC stock. An investor buys $10,000 of EFG stock on Monday and sells $10,000 of ABC stock on Tuesday. The settlement date for EFG stock is Wednesday (T+2), at which time the payment of $10,000 must be made in full. The available cash is still at $5,000 as the sale of $10,000 of ABC stock will not be finalized until Thursday. Therefore, the investor will not be allowed to buy $10,000 of EFG.
- Freeriding: This is another violation that can afflict a cash account. It prohibits investors from buying and selling securities before paying for them from their cash account.
- Good faith violation: This occurs when a cash account buys a stock with unsettled funds and liquidates it prior to settlement. For example, an investor has $20,000 of ABC stock though the cash account balance is $0. They sell $10,000 of ABC stock on Monday, which would net $10,000 in cash when it settles on Wednesday. On Tuesday, the investor buys and sells $10,000 of XYZ stock. This is considered to be a good faith violation as the account did not have the cash to buy XYZ in the first place.
Advantages and Disadvantages of Cash Trading
Cash trading doesn't involve the use of margin, which means they tend to be safer than margin trading accounts. For instance, a trader who purchases $1,000 worth of stock in a cash account can only lose the $1,000 that they invested, whereas a trader who purchases $1,000 worth of stock on margin could potentially lose more than their original investment. Cash trading also saves traders money in interest costs that would be incurred with margin accounts.
The downside of cash trading is that there is less upside potential due to the lack of leverage. For instance, the same dollar gain on a cash account and margin account could represent a difference in percentage return since margin accounts require less money down.
Another potential downside is that cash accounts require funds to settle before they can be used again, which is a process that can take several days at some brokerages.
Cash Trading vs. Margin Trading
In a cash account, all transactions must be long positions made with available cash. When buying securities in a cash account, the investor must deposit cash to settle the trade—or sell an existing position two business days in advance to free up the necessary funds. In this respect, cash trading is fairly straightforward.
A margin account, on the other hand, allows an investor to borrow against the value of the assets in the account in order to purchase new positions or sell short. Investors can use margin to leverage their positions and profit from both bullish and bearish moves in the market.
Margin can also be used to make cash withdrawals against the value of the account in the form of a short-term loan. For investors seeking to leverage their positions, a margin account can be very useful and cost-effective.
When a margin balance (debit) is created, the outstanding balance is subject to a daily interest rate charged by the firm. These rates are based on the current prime rate, plus an additional amount that is charged by the lending firm. This rate can be quite high. Moreover, leveraged positions will increase the riskiness as well as potential upside.