What Is a Cash Account?
A cash account is a brokerage account in which a customer is required to pay the full amount for securities purchased, and where short selling and buying on margin is prohibited. The Federal Reserve's Regulation T governs cash accounts and the purchase of securities on margin. This regulation gives investors two business days to pay for security (T+2).
In accounting, a cash account, or cash book, may refer to a ledger account in which all cash transactions are recorded. The cash account includes both the cash receipts journal and the cash payment journal.
- A cash account is a type of brokerage account where all transactions must be made with available cash or existing long positions.
- When buying securities in a cash account, the investor must deposit enough cash to settle the trade—or sell an existing position on the same trading day—so cash proceeds are available to settle the buy order.
- Unlike a margin account, cash accounts do not allow short selling or trading on margin.
Understanding Cash Accounts
In an investing context, investors who are actively trading must be careful not to violate certain regulations pertaining to cash accounts. For example, they must be sure to have sufficient cash in their account and not try to pay for the purchase of securities by selling other securities after the purchase date. An investor who has no cash in his/her account may decide on Monday to make a stock purchase worth $10,000. To pay for this, he/she may sell other stock on Tuesday worth $10,000. But this would be a violation because the purchase would settle two days later, on Wednesday, before the sale settled on Thursday, meaning there would be no cash to cover the trade. This is known as a "cash liquidation violation."
An active investor with a cash account and zero cash available must also not buy security and then quickly sell it before a previous sale has settled to provide the necessary cash. This is known as a "good faith violation."
Cash account investors (with zero cash available) must also avoid trying to pay for the purchase of a security with the sale of the same security. For example, an investor might purchase $1,000 worth of a stock on a Monday and fail to have enough cash to pay for it within two days. To pay for it, he/she might then sell the same stock on Thursday, the day after the purchase was to be settled. This is known as a "free riding violation."
Cash Account vs. Margin Account
Unlike a cash account, a margin account allows investors to borrow against the value of the assets in their 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.
Margin accounts must maintain a certain margin ratio at all times. If the account value falls below this limit, the client is issued a margin call. A margin call is a demand for a deposit of more cash or securities to bring the account value back within the limits.4 The client can add new cash to their account or sell some of their holdings to raise the cash.
For example, an investor with a margin account may take a short position in XYZ stock if they believes the price is likely to fall. If the price does indeed fall, they can cover their short position at that time by taking a long position in XYZ stock. Thus, they earns a profit on the difference between the amount received at the initial short sale transaction and the amount they paid to buy the shares at the lower price (less their margin interest charges over that period of time).
In a cash account, the same investor in this scenario must find other strategies to hedge or produce income on their account (since they must use cash deposits for long positions only). For example, they may enter a stop order to sell XYZ stock if it drops below a certain price, which limits their downside risk.