In this video Ross, from Warrior Trading talks about the types of accounts available to online active traders. He discusses the differences between margin, cash, and retirement accounts when opening an account with their U.S. online broker.
Hey, everyone. Ross here from Warrior Trading. I want to talk to you for a moment about Margin Versus Cash Versus Retirement Account.
When you go to your broker, and you decide you want to open a trading account, if you're thinking about a day trading account or even just an investing account, you have three options at your disposal here in the United States.
Your first option is a cash account. Now, when you deposit, let's say, $25,000 into a cash account you literally can only trade with the cash available. Because trades take two days to settle, if you take a trade today where you buy $25,000 worth of stock and you sell it, then tomorrow when you log in you will not have any buying power available because you have to wait two days for that first trade to settle. So effectively you can only trade a couple times a week depending on how much buying power you use on each trade. Clearly, that would make it very difficult to be a day trader, right? That's why we also have margin accounts.
A margin account in the United States will give you the ability to have trades settled instantly. So, if you take a day trade for $25,000 as soon as you press the sell button, that $25,000 is back on your buying power, and you go ahead and take trade number two, number three, number four. You can trade 1,000 times in one day with that same $25,000 amount. Here's the key, you need to have a minimum of $25,000 in your account in the United States to be able to day trade on margin. If you have less than $25,000 you can day trade, but you are restricted to the PDT level, or the PDT rule, which limits how many trades you can take in a five-day rolling period. I'll have a separate video where I talk about the PDT rules, all right. Your first account type is cash, and your second is a margin account.
Now, the benefit of the margin account is twofold. The first is that your trades settle instantly. The second is that with margin comes leverage. So, when you put in $25,000 you get four times leverage, which means your buying power will show, not as $25,000, but as $100,000 of buying power. That's during the day. Most brokers will then restrict your buying power overnight to just two times, so you would still have $50,000 of buying power to hold stocks overnight. Clearly, with this privilege comes a lot of responsibility to trade in a way that manages your risk because you could potentially lose.
If you take a $100,000 trade and you lose $50,000 of it, well you just lost the $25,000 cash that you put in the account, and now you owe your broker an additional $25,000, so you have to use leverage and margin very carefully. But, it's a choice whether or not you want to trade using that available buying power, or simply use your cash value and just actively trade that again, and again, and again. We've got cash accounts, and we've margin accounts. I personally use a margin account.
The third account type is a retirement account. With a lot of brokers, you can set up an IRA account. That's an individual retirement account. The advantage of IRA accounts is that they're tax deferred. They're actually tax free while they grow. There is limits to how much you can put into an IRA each year, and there are some income limits as well. But, if you put in, let's say, $5,000 into a traditional IRA, then once it's in that IRA all of the growth is tax free. However, when you go and take the money out at retirement age, 59 1/2, 65, as you're getting older, you have to pay income tax on the withdraws.
The second retirement account is a Roth IRA. Now, a Roth IRA when you put the money in, and it grows tax free you're fine. And when you take the money out its tax free as well. In order to have a Roth IRA you either need to deposit directly into it, however, there are income limits that prevent high income individuals from depositing directly into a Roth IRA. What many people will do is they will deposit into a traditional IRA, and then they will make what's called a backdoor conversion where they convert the traditional IRA into a Roth IRA. At the time of conversion, they have to pay income tax on the amount. And then from that point forward, you have a Roth IRA, the growth is tax free, and the withdraws are tax free.
The biggest disadvantage with trading in an IRA account is that you can't take the money out before 59 1/2 years of age without taking a penalty and having to pay income tax on it. So as long as you don't mind the knowledge that you can't touch that money until you're nearly 60 years old, it's a great way to trade. I also use an IRA account. I have two accounts. I have a margin account and an IRA account. A cash account really for me has zero value as an active trader, but as a long-term investor it may be an account type that's a good fit for you.
I hope this has helped you understand the different account types that you have at your disposal. As usual, if you have any questions don't hesitate to reach out.
In this video Ross, from Warrior Trading talks about the pattern day trader rule. This rule states that traders are allowed three trades in a 5-day period if your account is under $25,000 and it is a margin account.
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