Avoid These Common Cash Account Trading Mistakes or Face Severe Penalties

Online brokerage accounts make trading a seamless process, but there are certain rules investors need to follow. One of the most common pitfalls has to do with trade settlement. Shares purchased or sold with funds that have not been adequately settled will result in violations. Although violations can occur in both cash and margin accounts, they are far more prevalent in the former. Below, we outline key issues investors need to be aware of when trading in cash accounts. 

What Is a Cash Account?

A cash account is a type of brokerage account that allows investors to purchase securities using only funds available in their account. They cannot borrow additional funds from their broker. This type of account is governed by Regulation T, which ensures that investors are limited to using their own, settled funds for trades.

A cash account is typically the default type of account a broker will open for new clients, unless they specifically request a margin account. Cash accounts are also standard for individual retirement accounts (IRAs).

Cash Account vs. Margin Account

Unlike cash accounts, margin accounts allow investors to pay for securities with funds borrowed from a broker. The funds can be used to leverage the account’s buying power or to place trades while the actual cash is being settled. 

Cash accounts limit risk to the amount invested. By contrast, margin accounts introduce leverage, allow account holders to carry positions greater than the account’s cash value, and may amplify gains and losses alike.

Common Cash Account Violations

Good Faith Violations

Closing a position before it was paid for with settled funds is considered a “good faith violation,” as the investor made no obvious effort to deposit additional cash into the account prior to the settlement date. Brokers choose how to enforce these violations, and each broker may enforce them differently. Having three or more good faith violations within a 12-month period will likely result in a 90-day restriction on your account that limits you to trading fully funded positions only.   

Freeriding Violations

An investor commits a freeriding violation when they buy securities in a cash account without enough settled funds and sell them before enough funds settle to fund the original purchase.  This violation may generate more severe consequences than the others; a broker may take action immediately after the first violation and restrict trading to fully funded purchases for 90 days.  

Cash Liquidation Violations

This violation happens when an investor buys securities without enough settled funds and then sells shares in a different security to cover the purchase. Because the first trade settles before the second one, the investor won’t have the necessary settled funds in time to cover the initial buy, resulting in a violation. The consequences of this violation are less severe. After more than one violation within a specified time, a broker may restrict account access for 90 days. 

The Bottom Line

Cash accounts come with greater settlement-related restrictions than margin accounts. The consequences of violating these restrictions are inconvenient, at a minimum, but can also become costly, depending on an investor’s circumstances. Knowing the rules makes it easy to avoid these cash account violations.