What is Cash Trading?
Cash trading is the buying or selling securities by providing the capital needed to fund the transaction without relying on margin. Cash trading is the purchase or sale of Securities using the money required to support the trade without needing a Margin.
Cash trading is only possible if the account contains enough cash to complete a trade.
Understanding Cash Trading
Cash trading is buying and selling securities with cash in hand rather than borrowing capital or using a margin. Most brokers offer cash trading accounts as the default account type. These accounts are more accessible to maintain and open than margin accounts because no margin is required.
These accounts are only suitable for traders due to the need for margin. Long-term investors can use these accounts because they do not typically purchase securities on margin and don’t require rapid settlements.
The Settlement Date is when the transaction has been deemed consummated, and the buyer must complete the full payment. In 2017, stock trades in accounts must be settled within two business days. Previously, the settlement time was three days. Settlement is referred to as T+2-trade date plus two business days.
The settlement involves the transfer of securities into the buyer’s and cash into the seller’s accounts. Regulations T contain the rules that govern cash accounts.
- Violation of cash liquidation: One can only buy when sufficient money covers the trade. A cash trading account, for example, has $5,000 in cash available and $20,000 in ABC stock. On Monday, an investor purchases $10,000 in EFG stock and, on Tuesday, sells the same amount of ABC stock. The settlement date of EFG stock will be Wednesday (T+2), at which point the $10,000 payment must be completed. As the sale of ABC stock, which will finalize on Thursday, still needs to be completed, there are still $5,000 in cash available. The investor is not allowed to purchase $10,000 of EFG.
- Freeriding is another offense that can affect a cash account. Investors are prohibited from buying and selling securities without paying them with their cash account.
- Good Faith Violation: When a cash account purchases a stock using funds that have not been settled, liquidating the stock before settlement. An investor, for example, has $20,000 worth of ABC stock, but the balance in his cash account is $0. On Monday, they sell the $10,000 price of ABC stock. This will result in $10,000 cash at the settlement on Wednesday. The investor sells $10,000 worth of XYZ on Tuesday. This violates good faith, as the account didn’t have enough cash to purchase XYZ.
Cash Trading: Advantages and disadvantages
Therefore, cash accounts do not use margins and are safer than margin accounts. Cash trading is safer than margin accounts. For example, a trader can lose only the $1,000 invested in stock when they purchase it on a cash basis. However, a trader buying $1,000 of inventory using a margin may lose more. Cash trading saves traders interest costs incurred by margin accounts.
Cash trading has the disadvantage of having less upside due to the absence of leverage. The same dollar gain in a margin and cash accounts may represent a different percentage return because margin accounts require a lower down payment.
Cash accounts can also be a downside because they require the funds to settle before they can be used. This can take several business days for some brokerages.
Cash Trading vs. Margin Trading
All transactions in a cash account must be Long Positions and made with cash available. Investors who wish to buy securities on a cash basis must either deposit the money required to complete the transaction or sell their existing positions two days before the purchase date to raise funds. Cash trading is straightforward in this regard.
A margin account allows investors to borrow against their assets to buy new positions or sell short. They can leverage their jobs to profit from bullish and bearish movements in the market.
Margin can be used for short-term loans or to withdraw cash against the account’s value. A margin account is a cost-effective and valuable tool for investors who want to leverage their position.
The firm will charge a daily rate of interest on the margin balance. These rates are calculated based on the prime interest rate plus an amount charged by the lending company. This rate is often relatively high. Leveraged positions increase both the potential upside and risk.