Day trading in a cash account is similar to day trading in a margin account. Margin is the ability to use leverage to buy securities. Trading under a cash account significantly lowers your trading risks. Under a cash account, traders are not able to use leverage, pattern day trade, short sell and traders are subject to the three-day clearing rule. In addition day traders with a cash account are not able to file taxes under a trader status.
Not only do cash accounts prohibit traders from purchasing stock on margin, but they also limit the number of times the same security can be bought and sold in one day.
Purpose for Rules
The rules imposed on a cash account are intended to protect individual investors. With research showing that active, speculative traders who don't diversify their portfolios often losing money , the Securities and Exchange Commission set these in place to prevent large initial losses in the stock market.
Types of Rules
Traders are subject to the three day clearing rule, which means after a trader with a cash account sells a security they must wait three business days to access the funds to trade again. However, traders under the three day clearing rule are still able to use any settled funds to buy securities. Furthermore, traders with a cash account are not allowed to short sell securities. Short selling is the act of selling borrowed shares and then buying the shares back. Lastly, traders with cash accounts are not able to use borrowed money to buy securities.
In 2001, the National Association of Securities Dealers (now FINRA, the Financial Industry Regulatory Authority) enacted Rule 4210, which established requirements for what they called "pattern day traders." Pattern day traders are defined as traders who meet the following criteria:
- Margin customers who buy and sell a security within a trading day four or more times in five consecutive business days
- The number of day trades must comprise 6% or more of their total trading activity during that five-day period
- Margin customers who incurs two unmet day trade calls within a 90-day period
Pattern day traders must maintain a minimum equity of $25,000 on any day the customer trades. Additionally, those who refrain from any day trading in their account for 60 consecutive days will no longer be considered a day trader.
If a trader with a cash account pattern day trades, then their account is frozen for 90 days. Traders are not able to withdraw unsettled funds due to the three-day clearing rule. Not being able to short sell or use leverage greatly lowers financial trading risk, because traders are not able to lose more than what is in their stock account.
Effects on Day Trading
Trading under a cash account severely limits the amount of trading you are able to do, due to the pattern day trader rule. In addition, because traders with a cash account are not able to pattern day trade, they are not able to file taxes under a trader status. Filing taxes under a trader status allows traders to deduct all of their capital loss against their income.
Day Trading Risks
Day trading is not right for everyone. Even trading with a cash account involves significant financial risk. Trading with a cash accounts puts you at a large disadvantage, because you are limited to three-day trades per week under a cash account.