The broker will ask you if you want a cash account or a margin account when you open a brokerage account. There are some major differences between the two account types, both positive and negative.
Choosing the account that works best for your trading style and needs is an important decision that could have significant ramifications for you financially. Understanding how a brokerage settles trades can make the difference in your decision to use a margin account or stick with a cash account.
- Cash accounts are the more conservative choice—they don't permit borrowing money from the broker or the financial institution to buy stock.
- Margin accounts offer the convenience of borrowing money from your broker to make additional investments.
- The "regular-way" trade settlement process requires you to deliver the cash if you're buying, or the asset if you're selling, within a certain timeframe after the trade date.
- Your broker is responsible for settling trades even if you don't come up with the required cash or securities, so it has the right to penalize you with fees.
Cash accounts are the most conservative choice. They don't permit borrowing money from the broker or the financial institution to buy stock—there's no "trading on margin." This can decrease purchasing power, but it also helps prevent investors from incurring significant losses.
Most investors, particularly those who are just starting out, should be perfectly fine with a cash account.
You must pay for any trades in cash with this type of account, and you must do so by the required settlement date. This can restrict your ability to place trades more often because you might not have enough available cash settled and ready to deploy in your account at the moment you want to place your next buy order.
You'll also have to wait until trade settlement to make a withdrawal of the cash you raised from a sell order. Stocks held in a cash account aren't lent out by the brokerage to short sellers, those who borrow shares from a broker to sell.
Investors holding securities within a cash account will never be subject to a margin call within their account because there's no margin debt. Investors also avoid the risk of losing their assets due to rehypothecation exposure, a situation where their broker uses the investor's shares as collateral for the broker's loans from third parties.
You must behave much more conservatively when dealing with options when you have a cash account. Any calls you write must be fully covered, and any puts you write must be fully secured by cash reserves in the event of exercise.
Investing Using Margin
Margin accounts offer the convenience of borrowing money from your broker to make additional investments, either to leverage returns, for cash flow convenience while waiting for trades to settle, or for creating a de facto line of credit for your working capital needs. Your account effectively serves as collateral.
Investing using margin is risky and isn't really necessary for most investors.
Securities you hold in your margin account can be lent out to short sellers to generate additional income for the broker, and this can happen without your knowledge. You might not be permitted to claim the dividend as a qualified dividend subject to much lower tax rates if this happens and if the short sellers cover the dividend payment you are entitled to receive.
You might additionally be subject to rehypothecation risk.
You must instead pay ordinary personal taxes on the dividend income. This could result in you paying practically double the tax rate you otherwise would have because your broker was trying to earn more profit for its own income statement at your expense.
Trade Settlement Requirements
The "regular-way" trade settlement process requires that you deliver the cash if you're buying, or the asset if you're selling, by the end of a certain number of days following the trade date itself. This applies when you're trading stocks, bonds, options, or Treasury securities.
A brokerage often expresses this as "T + [insert the number of days here]."
The typical settlement schedule was T + 5 for many years, according to the Securities and Exchange Commission (SEC). Then the current trade settlement requirements for cash accounts were changed in 2017, as follows:
- Common Stocks = T + 2
- Corporate Bonds = T + 2
- Options (Calls and Puts) = T + 1
- U.S. Treasury Bills, Bonds, and Notes = T + 1
Potential Trading Sanctions
Regulation T states that if the investor's shortfall exceeds $1,000 in value, the broker must make a choice to either liquidate the investor's position or apply for an exemption from the regulators.
SEC Rule 15c3-3 states that the broker must buy replacement securities for the customer or apply for an exemption from the regulators if a long-held security hasn't been delivered within 10 business days following settlement.
Your broker is responsible for settling trades even if you don't come up with the required cash or securities, so it has the right to penalize you with fees. It can also take other remedial measures to protect its own interests if you fail to honor your financial commitments.
An Example of Sanctions
Imagine that you entered a buy order for shares of common stock but didn't come up with the cash to pay for them when the trade went to settlement. The broker would have to make it up out of its own pocket, then sell the shares to recover the funds.
It could go after you for the amount it lost on the transaction as a result of the movement in market value if the stock price declined in the meantime. This could expose you to substantial losses.
Your broker can close your account and ban you from doing business with the firm if you repeatedly fail to settle trades within your cash account. Additionally, if you trade too rapidly to the point where you're buying shares with the float generated from the settlement process, you can be slapped with a Regulation T violation, which will result in your account being frozen for 90 days.