There are several types of brokerage accounts, but mostly, they are variants of two basic account types: margin account or cash account.
Put most straightforward, a cash account requires the client to pay in full for the securities they buy for their account. If they have $500, they can only buy $500 worth of securities, and can’t use the securities in their account as collateral to borrow more money.
A margin account allows clients to borrow money from their broker to buy securities, using those securities as collateral for the loan.
Benefits of a Cash Account
The primary benefit of a cash account applies to those who have small trading accounts, which do not meet the pattern day trader (PDT) required margin of $25,000. The PDT does not apply to cash accounts.
If a trader with a cash account has the capital to support this, they can make hundreds of trades on a given day. The kicker here is that cash used in a trade needs to settle before it can be transacted with again.
The next benefit is that cash account holders have no risk of receiving a margin call. A margin call is when your broker decides to terminate the margin loan they’ve extended to you. In the situation of a margin call, your broker will usually liquidate the securities you bought to cover the loan.
If you owe them any more money after that, you’re required to deposit more cash or securities to cover that loan.
Drawbacks of a Cash Account
The biggest drawback to cash accounts for traders is that after making a transaction in a cash account, the cash used must go through a settlement period, which is two days after the trade date.
For example, you use $1,000 of that to make a day trade on Monday. That $1,000 won’t be available for trading again until Thursday.
So, while the PDT rule doesn’t apply to cash accounts, to make several day trades in a week, you need to use small portions of your account. Imagine if you had a $1,000 trading account, to make 10-day trades in a week, you’d need to limit your position size to $100 for each trade.
The next drawback for cash accounts is especially hard-hitting to momentum traders who have small accounts: you can’t sell securities short. Short selling requires a margin account because you’re borrowing the securities from your broker.
This hurts many momentum traders who love to short sell parabolic penny stocks.
Benefits of a Margin Account
The primary benefit of a margin account for traders is the intraday margin extended to you by your broker. The standard for retail brokers is 4-to-1 intraday margin and 2-to-1 overnight margin.
This means that if you have $1,000 in your trading account, you can trade with $4,000 intraday and $2,000 for any positions that you hold for more than one trading session.
The next benefit is the ability to short sell securities. Short selling is only allowed for margin accounts, so if short selling is part of your strategy, a margin account is basically required. It should be noted, though, that many brokers require you to have a certain amount of cash to be able to begin short selling.
For example, TD Ameritrade doesn’t allow you to short sell until you have $2,000 in your trading account.
Drawbacks of a Margin Account
The primary disadvantage of a margin account is that they’re subject to the pattern day trader (PDT) rule, which states that those with less than $25,000 of cash in their account can’t make more than three day trades within a rolling five day period.
For this reason, I recommend that most day traders with accounts who don’t meet the PDT requirement either split their account into two margin accounts, giving you six day trades in a rolling five day period, or use a cash account. The PDT doesn’t apply to cash accounts, but the cash used needs to be settled.
The next drawback is that you are vulnerable to a margin call, which usually leads to the liquidation of a position you would prefer to continue holding. Because cash accounts require you to buy securities with all of your own cash, you can’t receive a margin call.
However, you usually only need to worry about a margin call if you’re shorting a stock or close to maxing out your margin levels in a risky position.
The last thing I’ll say isn’t much a drawback, but it’s something to keep in mind when using margin. Borrowing on margin through most retail brokers is very expensive.
Some of them charge several percentage points above the prime rate, which means that you’re paying much interest, reducing your expected value on each trade in which you use margin.
Through my research, I’ve found Interactive Brokers to offer the cheapest margin to retail traders by a significant amount.
At any time, you can usually change your account type quite easily only by calling your broker. The major US brokerage firms have 24-hour customer service, for the most part, making an account type change quite easy for those of us in the States.
If your account doesn’t meet the PDT requirements, you should think hard about which account type suits you more.
Personally, I would recommend using small position sizes within a cash account, which gives you more opportunities to gain market experience through trading, rather than being too gun-shy and afraid of using one of your day trades.
However, for some, it might make more sense to keep “dry powder” in your margin account and only use your three day trades per week on A+ setups.