What Is a Cash Account?
A cash account with a brokerage firm requires that any securities transactions be payable in full from funds in the account at the time of the settlement. Short selling and buying on margin are thus prohibited in this type of account. 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. It's known as T+2.
In accounting, a cash account, or cash book, may refer to a ledger in which all cash transactions are recorded. The cash account includes both the cash receipts journal and the cash payment journal.
Key Takeaways
- A cash account is a type of brokerage account that requires that all transactions be payable in full on the settlement date with available cash.
- When buying securities in a cash account, the investor must deposit enough cash to pay for the trade, or sell other securities on the same trading day so that cash is available to settle the buy order.
- Unlike margin accounts, cash accounts do not allow short selling or trading on margin.
Understanding Cash Accounts
Investors who actively trade 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.
For example, an investor who has no cash in an account may decide on Monday to make a stock purchase worth $10,000. To pay for this, the investor sells other stock shares on Tuesday worth $10,000. This would be a violation because the purchase will settle two days later, on Wednesday, before the sale settled on Thursday. There would be no cash available in the account 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 or near-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 but fail to have enough cash to pay for it within two days. To pay for it, the investor 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, amargin accountallows an investor to borrow against the value of theassetsin an 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 toleveragetheir positions, a margin account can be useful and cost-effective. But keep in mind that 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 amargin call. This is a demand to bring the account value back within the limits. The client can add new cash to the account or sell some holdings to raise the cash.
For example, an investor with a margin account may take a short position in XYZ stock, believing the price is likely to fall. If the price does indeed fall, the investor can cover the short position by taking a long position in XYZ stock. The investor thus earns a profit on the difference between the amount received with the initial short sale transaction and the amount paid to buy the shares at the lower price, minus the margin interest charges.
With a cash account, the same investor would have to find other strategies tohedgeor produce income on the account. For example, the investor might enter a stop order to sell XYZ stock if it drops below a certain price. That limits the downside risk.
