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 don’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.
