Rules every stock or options trader should know about their account before placing their first trade
It’s important to know the differences between cash accounts and margin accounts.
Both are equities accounts where you can trade stock or stock options, but each account type has its own set of rules. Knowing the rules and limits for your account ahead of time will save you the headache of having to figure them out last minute.
Cash accounts are equities accounts in which trades are placed with…. you guessed it. Cash!
All transactions are paid in full at trade time with the available cash in your account. While, this might sound like common sense, when we talk about margin accounts, you’ll understand why it’s important to point this out.
The benefit of having a cash account is you can day trade as much as you like provided you have the available cash in the account. The downside is once you close a position, the proceeds from the transaction are not immediately available because they go through what is called a settlement period. Stocks take two business days to settle, while options take one business day.
For you all of you aspiring option traders out there, it is also important to note you cannot place stock option spreads in a cash account. You can, however, place index option spreads depending on what options privileges your broker has granted your account. However, this must be done by completing an options application form and returning it to your broker.
Margin, in this case, means borrowed funds. A margin account differs from a cash account because they allow traders to borrow money by using the value of their assets to place trades. Using borrowed funds instead of solely relying on their available cash balance (hence why we pointed this out earlier) allows for a trading advantage.
There are a couple of ways to borrow margin. The most common is to use the leverage buying power provided to you by your broker. Brokers will offer a “line of credit” so to speak which is often a ratio of the available cash in the account. If a broker offers four-to-one leverage for day trading, this means for every $1 in cash you have, the broker will let you buy up $4 worth of securities with margin. When margin is used to day trade, the proceeds from that trade are immediately available for use in the account. Not having to wait the settlement period makes margin accounts the ideal account for day trading.
With the overnight margin rate, leverage is two-to-one. Keep in mind, leverage ratios may vary by symbol and broker.
Another way to use margin is to borrow against the value of the assets in your account to purchase new positions or sell short. When you do this, an investor can use margin to leverage his 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 marginable equities in the account as a short-term loan.
As with cash accounts, there are rules for margin accounts. The one that stands out among the rest, which often takes new traders by surprise, is the rule is known as the Pattern Day Trading (PDT) rule.
The PDT is an industry-regulated rule requiring brokers to flag any account that completes four day trades, within a look back period of five trading days as a pattern day trading account.
That doesn’t sound so bad, right? But wait! There’s more!
Once an account is flagged for pattern day trading, a restriction is placed on accounts that have net worth amounts below $25,000 which, in turn, only allows traders to close existing positions. In other words, you cannot open any new positions or place new trades unless you meet the net worth requirements. Ouch! Can you imagine getting ready to place the perfect trade and being stopped with an order rejection because you didn’t know about that rule? To make the matter worse, the restriction lasts for 90 days! That is, of course, if you can’t meet the minimum net worth requirements.
Believe it or not, this rule is not your enemy- though it may seem like it- because people who skip over the rules think they can trade without limits and then get disgruntled when this rule gets in their way. The rule is in place to prevent people from losing money as day trading on borrowed funds can be risky, especially if you end up owing money you can’t afford to pay back.
Last, but not least, you can place short trades in a margin account. Short trades are call shorting stock, or short selling, and it involves the sale of stock the seller does not own and has taken on loan from a broker. Short sellers take these trades because they believe a stock’s price is going lower and if they short the stock today, they’ll be able to buy it back at a lower price at some point in the future and make a profit.
But, be aware of certain dates before you go short. For example, if you are short a stock the day before its ex-dividend day, you will be required to send a payment “in lieu” of the dividend that is owed to the stockholder.
Some other fun facts about margin accounts are:
- You only pay interest if you use margin to hold positions overnight. You will not pay interest on margin used for day trading.
- If a trade isn’t going your way, and you used margin to enter your position, you can end up owing the borrowed money back to the broker, which is called a margin call.
- Your broker can liquidate shares of your assets to meet a margin call if you do not have available cash. This usually results in added liquidation fees, so try to be aware of this.
- Margin privileges are not offered on individual retirement accounts (IRA or Roth IRA) because they are subject to annual contribution limits, which affects the ability to meet margin calls.
- Share lending in margin accounts can be lent out to another party or used as collateral by the brokerage firm at any time without notice or compensation to you when there is a debt balance on the account where you have accessed the margin funds. If the account is in a credit state where you haven’t used the margin funds, the shares can’t be lent out.
- You can place option spread trades on stocks and indices, provided you have approval by your broker, which is based completing their options application form.
Be sure to check any specific rules your broker has for cash or margin accounts. Each account type has pros and cons along with separate rules and regulations. Make sure you are aware of any limitations before you start trading. Check out more posts at www.youcantrade.com/insights or on our YouTube channel.
Disclaimer: The author is not a financial advisor and the following should not be taken as financial advice. This is by no means a complete discussion of the pros and cons of trading and/or investing. Please consult your own qualified advisors to determine what is appropriate and best suited to your specific investment objectives and risk tolerance.