Cash Trading Definition, Rules, vs. Margin Trading

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.

Understanding Cash Trading

Cash trading refers to the purchase and sale 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 their cash 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 settle within one business day or T+1. Settlement takes place on the next business day if the trade is initiated on a weekend or holiday. The settlement process involves transferring the securities to the buyer’s account and the cash into the seller’s account. The rules governing cash accounts are contained in Regulation T.

Special Considerations

The most common types of potential violations that an investor should be aware of if they are cash trading are cash liquidation violation, freeriding, and good faith violation. All of these actions are prohibited by the SEC and the Financial Industry Regulatory Authority (FINRA).

Cash Liquidation Violation

A trader cannot buy securities if there is insufficient cash in their account 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 Tuesday (T+1), 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 Wednesday. Therefore, the investor will not be allowed to buy $10,000 of EFG.

Freeriding

Freeriding 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. Investors can unintentionally freeride when they buy assets with the proceeds of an unfinalized sale. Brokers and dealers must freeze or suspend the accounts of any traders who are caught freeriding for 90 days.

Good Faith Violation

This occurs when a cash account buys a stock with unsettled funds and liquidates it before it settles. For example, an investor has $20,000 of ABC stock with a cash account balance of $0. The investor sells $10,000 of ABC stock on Monday, which would net $10,000 in cash when it settles the next day. The investor commits a good faith violation if they buy and sell $10,000 of XYZ stock on the same Monday as the account didn't have the cash to buy XYZ in the first place.

Advantages and Disadvantages of Cash Trading

Advantages

Cash trading tends to be safer than margin trading accounts because it doesn't involve the use of borrowed capital or leverage. 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.

Remember, margin accounts involve borrowed capital. This means there is an additional cost associated with these accounts. Traders who use their cash accounts end up saving money in interest costs that they would pay to use margin accounts.

Disadvantages

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 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 or 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.

The Bottom Line

Traders have different options to help facilitate their trading activity. This includes cash through a cash account. Cash trading can only take place if an investor's brokerage account has enough money to complete the transaction. This is different from using capital from a margin account, which is capital borrowed from a broker-dealer. Traders should make sure that the cash is available to facilitate trades through their accounts or risk having them frozen by financial regulators if they violate the rules.