This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
The cash buffer in a trading account is the cash that the trader holds in the account, uninvested, available to meet margin calls, to fund new positions, or to absorb drawdowns. The cash buffer is the trader's defence against the unexpected, and the right size is a function of the strategy, the volatility of the holdings, and the trader's risk tolerance. The most common mistake is to fully invest the account, which leaves no buffer for the next drawdown or the next opportunity.
Why hold cash at all
The most common reason is defence. A drawdown in a leveraged position is funded from the account's cash, and a trader who has no cash is forced to close other positions to meet the call. The cash buffer absorbs the drawdown, and the trader can hold the position through a normal fluctuation without being forced out.
A second reason is opportunity. A trader who has cash in the account can take advantage of a sudden drop in a stock the trader has been watching, or a sudden rise that the trader wants to short. The trader who is fully invested cannot react, and the missed opportunity is a real cost.
A third reason is psychological. A trader who is fully invested is exposed to the full volatility of the holdings, and the stress of watching the account fall by 10% in a day is a real cost in terms of sleep, focus, and decision quality. A cash buffer reduces the volatility of the account, and the trader can think more clearly about the positions and the strategy.
How much cash is enough
The honest answer is that it depends on the strategy and the volatility of the holdings. A trader with a buy-and-hold portfolio of large-cap stocks can hold a smaller cash buffer (5% to 10% of the account) because the volatility is lower. A trader with a portfolio of small-cap stocks or leveraged positions needs a larger buffer (20% to 50% of the account) because the volatility is higher.
A trader with a single leveraged position needs a cash buffer that is large enough to absorb a 20% gap on the position. On a €10,000 position, the buffer is €2,000, which is 20% of the position. The buffer is in addition to the initial margin, and the total cash in the account is the initial margin plus the gap buffer.
A trader with a diversified portfolio of unleveraged positions needs a smaller buffer, because the drawdowns on individual positions are smaller and less correlated. A 5% cash buffer on a diversified portfolio of large-cap stocks is usually enough to absorb a normal drawdown, and the trader can use the cash to fund a new position when the opportunity arises.
The opportunity cost of cash
Cash has an opportunity cost. A trader who holds 20% of the account in cash is giving up the return on that 20%, which over a long period is a meaningful drag on the portfolio. A trader with a 7% expected return on the portfolio and a 20% cash buffer gives up 1.4% per year, which over 20 years is a substantial difference in the final wealth.
The opportunity cost is real, and the trader should weigh it against the cost of not having the buffer. A trader with a long-term horizon and a low-volatility portfolio can afford a smaller buffer, because the cost of a drawdown is smaller. A trader with a short-term horizon and a high-volatility portfolio needs a larger buffer, because the cost of a drawdown is larger.
The compromise is dynamic. A trader can hold a smaller buffer (5% to 10%) in calm markets, and a larger buffer (20% to 30%) in volatile markets. The shift in the buffer is a function of the trader's view on the market, and the view should be based on the trader's analysis, not on the trader's mood.
Where to keep the cash
The cash in the trading account is usually held in a money market fund or in the broker's cash sweep program. The money market fund pays a yield that is close to the central bank rate, and the cash is available to fund trades or meet margin calls. The broker's cash sweep program pays a yield that is usually below the money market fund, but the cash is immediately available.
The choice between the two is a function of the yield and the convenience. A trader who values yield can put the cash in a money market fund and accept a one-day delay in funding a trade. A trader who values convenience can put the cash in the broker's cash sweep program and accept a lower yield.
The cash is not insured the way a bank deposit is insured. The money market fund holds the cash in short-term government securities, and the value of the fund can fall if the securities default. The broker's cash sweep program is usually a deposit at a tier-one bank, and the deposit is protected by the deposit insurance scheme in the broker's jurisdiction. The two are different in their credit risk, and the trader should understand the difference.
When to draw down the cash
A trader should draw down the cash when the opportunity is real and the cost of missing the opportunity is high. A trader who has been watching a stock fall by 20% and has the cash to buy can take the position, and the cash is converted to a position. The drawdown on the cash is a real cost, but the cost is offset by the position's expected return.
A trader should not draw down the cash to meet a margin call on a losing position. The losing position is the source of the call, and adding cash to a losing position is doubling down on a bad bet. The honest answer is to close the losing position, take the loss, and preserve the cash for a better opportunity.
Related resources
Where to start
If you are deciding how much cash to hold, the most useful exercise is to calculate the cash needed to absorb a 20% drawdown on your positions. Our broker comparison lists the cash sweep programs and the money market fund options at each broker, which together tell you what the yield and the convenience look like before you choose.