Day trading is a popular approach for making money online. It refers to a process where investors buy and sell financial assets like stocks, currencies, and commodities with the goal of generating short-term profits.
Day traders need to first create accounts with brokers who act as intermediaries in the market. Brokers like Robinhood and Schwab simply create a platform where people buy and sell assets.
There are two primary accounts in day trading: cash account and margin account. In this article, we will focus more on cash accounts, how they work, and whether they are the best for you.
What is a cash account?
A cash account is one where all transactions are handled with funds in a customer’s account. In this case, assuming that you have a $10,000 account, it means that your maximum trade or investment will be worth $10k.
In some cases, a trader with a cash account can give the broker the permission to lend your shares to other third parties. This lending often attracts some small interest, which is paid to the account holder.
Share lending is a popular approach and is often used by short-sellers. A short seller is a person who borrows shares, sells them, and then buys them back. They profit when the price of an asset drops.
Cash account vs margin account
The other type of account that many brokers offer is known as a margin account. This is an account where the broker extends some leverage to a trader. This leverage or loan is used to boost a trader’s earnings.
The concept of leverage is relatively easy to understand. Assume that a stock is trading at $10 and you have $1,000 in a cash account, it means that the maximum shares you can buy are 100. If the stock doubles to $20, your profit will be $1,000.
In a margin account, the broker can give you a 1:10 leverage. In this case, it means that you can buy 1,000 shares. If the stock doubles, your profit will be much higher!
A margin account has several benefits compared to a cash account. First, with a margin account, you can make more profits if trades go your way.
Second, you can also benefit regardless of the asset’s direction. You can buy if you expect the asset to rise and short when you believe it will drop. In cash accounts, you can only make money by buying an asset.
Third, margin accounts enable you to buy expensive assets. For example, with a $500 account, you can only buy fractional shares of a stock trading at $2,000. With a margin account, it is possible to execute trades of more expensive assets.
How a cash account works
A cash account is one of the easiest ones to open and manage. The first thing you need to do is to find a good broker that provides these accounts. If you are in the US, all companies like Robinhood, Schwab, and Fidelity offer cash accounts.
On the other hand, if you are not in the US, there are many brokers that offer these solutions. Interactive Brokers is one of the biggest international brokers that has cash accounts.
After creating an account, all you need to do is to deposit your funds and then start trading. When you buy a stock, the funds will be moved from your account.
Day traders, depending on their countries, are required to pay taxes on their profits. They do this by reporting their income and paying the set tax. In the US, they do this by paying capital gains taxes.
Pros of a cash account
In most cases, day traders prefer using margin accounts since the leverage makes it possible for them to open larger trades and make more money. Still, some people prefer using cash accounts.
The first benefit of a cash account is that it reduces the chances of having a negative balance. Since margin trading involves using borrowed money, a big loss can translate into a negative balance. With a cash balance, the biggest loss you can have is where you lose all your money.
Second, a cash account does not apply the Pattern Day Trader (PDT) rule. The PDT rule was set by the Financial Industry Regulatory Authority (FINRA) to discourage excessive day trading.
It has several attributes such as requiring that a trader should have at least $25k in their trading account.
Third, a cash account is a good way to develop discipline when day trading. Also, it helps to reduce the risks of short-selling such as infinite loss potential.
Why a cash account is not ideal for day trading
Cash accounts are usually ideal for investors who buy and hold assets for a long time. In most cases, day traders should always focus on using margin accounts.
First, day trading involves buying and shorting assets within a short period. They buy assets they hope will rise and short those they hope will fall. With a cash account, you can only place long trades, meaning you cannot make money in a bear market.
Second, a cash account limits the assets you can trade profitably. For example, if you have a $1,000 account, you cannot take advantage of big movements in highly expensive stocks like Berkshire Hathaway.
Third, a cash account has some settlement cons that margin accounts don’t have. In cash accounts, all transactions must be settled in full with the available funds.
There are other violations that come with cash accounts. First, there is a good faith violation where you buy a stock and sell it before paying the full price with settled funds.
Second, there is a freeriding violation, where you buy a stock and pay for it using proceeds from a sale of the same stock. For example, assume that you have $0 and you execute a $10,000 buy trade.
In this case, no trade is executed since you have no cash in your account. Then, if you sell the $10,500 stock, a freeriding violation has happened.
Third, there is a cash liquidation violation, where you buy a stock and cover the cost of that purchase by selling other fully paid securities after the purchase date.
Is a cash account ideal for day traders?
No. As mentioned, using a cash account for day trading is not ideal since it has many limitations.
Do cash accounts have margin calls?
A margin call is a situation where a broker closes a leveraged trade when it moves to a certain loss threshold. Therefore, a cash account does not have a margin call.
When is a cash account ideal?
A cash account is usually recommended when one is buying assets and holding them for a long time.
External useful resources
Cash Account Major Info – Investor.gov