For me, learning how to trade stocks was a bumpy road. While I wouldn’t say it’s all smooth now, I’ve come a long way and looking back, I wonder why it was so hard to find basic information about trading in the beginning. Most of what I know now came from trial and error. A simple guide with some clear explanations and tips would’ve saved me some time and money. If you’re interested in how I got started with day trading, click below to listen to my podcast, The Unraveled Trader.
The Two Types of Accounts for Trading
You need to open a brokerage account if you want to trade or invest in stocks. When I first started trading, I had a cash account but I didn’t even realize there was another kind- a margin account. Most day traders trade out of a margin account so a lot of what you’ll find online about trading accounts pertains only to margin accounts.
So what’s the difference between a cash account and margin account?
A cash account is a simple brokerage account that you fund and then you use the money you put in to buy stocks. A margin account gives you extra buying power, so you fund the account and your broker will allow to buy and sell stocks (with certain limitations of course) with your money plus borrowed money from the broker. So, if you fund a cash account with $2,000, you can then buy up to $2,000 worth of stock and that’s it. If you fund a margin account with $2,000, you’ll have a greater buying power depending on how long you plan to hold a stock. Generally, you get 4 times the amount you put into your margin account for day trades. So, a margin account with $2,000 will get you $8,000 worth of buying power for day trades. Overnight buying power is usually two times what you put in so a $2,000 margin account will give $4,000 to work with for buying positions to hold overnight. It’s important to check with your specific broker about buying power if you open a margin account so you know exactly what you are able to do.
Now, if you buy stocks on margin (using borrowed money from your broker), you have the leverage to make more money by entering a position larger than what you could buy on your own. However, this also comes with a greater risk. Because you are borrowing money, you could lose all of your money and end up owing your broker if you lost funds you borrowed on margin.
If you are interested in shorting stocks, you will have to open a margin account. Cash accounts cannot be used for taking short positions.
Cash or Margin? Which is Better for a New Trader?
If you are brand new to trading, it is probably safest to start with a cash account. Put only as much money in it as you are willing to lose. It’s really important to remember that most people lose money day trading, and even the most successful day traders go through periods of loss in the beginning. Start with a small account when you first begin trading and only trade small positions as you learn the ins and outs of the market. The goal in the very beginning shouldn’t be to make a ton of money (because it just won’t happen), but rather to learn how to execute good trades. You can size up later once you’ve learned how to trade with some rate of success and once you’ve learned to control your risk. You can also change your account from a cash account to a margin account when you’re ready to take the next step.
Rules Governing Cash and Margin Accounts
You cannot execute unlimited day trades in either a cash or a margin account. It’s crucial to understand the rules surrounding day trading before you start trying to day trade.
Cash accounts are subject to settled funds. If you have $2,000 cash in your account and you buy $500 worth of stock on Monday and then sell that position the same day, you now have $1,500 of settled funds in your cash account. Let’s say you sold your position at a profit for $550. That $550 will show in your account as unsettled funds. When you sell a position, it takes two days (usually- I’ve heard it can take three with some brokers) for those funds to settle. If you want to execute another day trade in your account, you need to use settled funds. In this example, you have $1,500 left to work with for the day. You will need to wait until Wednesday to use the $550 from the sale of your position on Monday. You can use unsettled funds to buy a stock, but you cannot sell a stock purchased with unsettled funds until after those funds have settled in your account. If you decide to day trade with a cash account, you should plan your trades so you don’t find yourself with no settled funds to work with. On any given day, use only half of your total account so that you have the other half for the following day while you wait for the previous day’s funds to settle. Using unsettled funds to buy and sell a position will result in a Good Faith Violation. Committing Good Faith Violations can result in a suspension of your account for 90 days and the sale of your positions if you’re holding any. You will get warnings from your broker the first three times you commit a Good Faith Violation. The fourth violation results in the aforementioned penalties.
Margin accounts with a balance over $25,000 are free from any day trading restrictions. You do not need to worry about settled funds. You can buy and sell as many times as you’d like in a day. If a margin account has less than $25k in it, it is subject to the Pattern Day Trader rule (PDT rule). The PDT rule states that no more than three day trades can be executed in a five business day rolling period. This severely limits day trading. Breaking this rule results in having your account suspended for 90 days. The PDT rule only limits your day trades, so if you hold a position overnight, it does not count as one of your three allowable trades. I personally day trade in a margin account that is under $25k so I have to navigate the PDT rule. I actually like being subject to this rule (for now) because it prevents me from overtrading, and it has forced me to select my trades very carefully. I attribute some of my recent successes to this rule. But not everyone shares this opinion, and there are some days when I don’t have any day trades available and I’ll see a really great opportunity that I have to pass on.