What is Cash Trading
Cash trading is a method of buying or selling securities by providing the capital needed to fund the transaction without relying on the use of margin. Cash trading is achieved using a cash account, which is a type of brokerage account that requires the investor to pay for securities within two days from when the purchase is made.
BREAKING DOWN Cash Trading
Cash trading is simply the buying and selling of securities using cash-on-hand rather than borrowed capital or margin.
Trades placed in cash accounts require up to three business days for the funds to fully settle before they can be used to buy and sell again. The settlement process involves transferring the securities to the buyer’s account and the cash into the seller’s account. Good faith violations occur when the purchase of a security uses funds that haven’t settled, and restrictions can be imposed in cases where there are multiple good faith violations.
The rules governing cash accounts are contained in Regulation T, which prohibits the practice of “free riding” or investors buying and selling securities before paying for them from their cash account. The rules state that broker’s must freeze cash accounts for 90-days following these infractions, requiring the investor to fund securities purchases with cash on the trade date.
Cash Trading Accounts
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, but 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.
Benefits & Drawbacks
Cash trading doesn't involve the use of margin, which means they tend to be safer than margin trading. For instance, a trader that purchases $1,000 worth of stock in a cash account can only lose the $1,000 that they invested, whereas a trader that 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 50% 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.