Choosing a brokerage account
When you first sign up for a brokerage account, you will be given a choice about what account you would like to open. There are some variances from platform to platform but the two account options you will almost always see is a cash account and a margin account.
You need to determine what kind of investor/trader you are and make your decision accordingly. The two account options provide users with vastly different approaches to their trading endeavors. Let’s take a closer look at how each account works and what they provide for you.
How a cash account works
As the name suggests, a cash account is an account that you will be able to buy securities with, provided you have an actual sum of cash in your account to open a position. You will either need to deposit cash into your account or sell a security that you hold to cover the purchase of another. As you can see, the idea is pretty simple: if you have the cash, you can buy more securities up front. (1)U.S. Securities and Exchange Commission."Cash Account."
An interesting opportunity that a cash account provides traders is the ability to lend out their securities. This is simply called securities lending. You can lend your shares to short sellers or hedge funds which can earn the trader interest. The basic idea is that you let your broker know that you have certain shares you are willing to lend out. If the broker finds that there is a demand for these shares, they will send you a quote on what they would be willing to pay you to lend these shares out for.
The idea is that you make a profit off of the interest on these shares. The benefit of this transaction is that you will be able to maintain your long position while making interest on your shares in the short time from loaning them out to short sellers. While this is an attractive proposition, not all brokers give you this option and some will require a minimum number of shares to be owned or loaned out.
How a margin account works
A margin account also requires that the trader makes a deposit but the broker will also allow the trader to borrow money from the brokerage firm against the assets they own. Traders can use margin to leverage their positions to help them come away from downward or upward trending markets advantageously. (2)U.S. Securities and Exchange Commission."Margin Account."
The brokerage firm is obviously not giving you the ability to trade on margin out of the goodness of the heart. No, you need to keep in mind that the firm will charge you interest on the “loan.” Essentially, you are betting that the security you are purchasing on margin will grow faster than the interest rate of your loan. Your margin interest rates can be quite high but they do vary to some degree between different brokerage firms. All in all, the interest on your margin account will be about 3-4% higher than your average credit line from the bank.
You won’t be put on a repayment schedule with your interest rates but these rates will continue to add up every month. This is why the brokerage firm makes sure that you are using your existing securities as collateral for your margin account repayment.
While you may not have a set time to repay your interest, you will need to keep your margin account within a certain ratio. If your account drops below a certain value, the brokerage will issue a margin call. This is basically a demand on the trader to bring their account back within a specified limit by either selling off securities or depositing more cash into their account. (3)U.S. Securities and Exchange Commission."Margin Call."
The key differences between the two accounts
As you can see from the two accounts, there are a few similarities but for the most part these two account options are starkly different. Let’s take a look at the key differences.
A cash account does not give you the option to trade with leverage. Leverage is the ability to borrow money from the brokerage firm against your trade. For example, if you traded at 30:1 leverage and you only put in $100 that would mean you were actually holding a position to the value of $3,000. On the other hand, a margin trading account does allow you to leverage your positions. (4)U.S. Securities and Exchange Commission."Investor Bulletin: Understanding Margin Accounts."
While trading on margin can certainly increase your profits should you pull your trade off successfully, it can also bring with it its own risks. The first risk is by simply trading on margin. If for example, you buy $2,000 worth of stock and you borrow an additional $2,000 but the stock price falls by 10%, you would then have lost $200 on each making it a total loss in value of $400. If you were simply using a cash account, it would have been a flat $200 value loss.
Then we come to account requirements. With a standard cash account there is no minimum cash deposit requirement. You can typically deposit as much as you are comfortable with. However, with a margin account, you will need to make a minimum deposit of $2,000.
That is not the only requirement of a margin account though. In addition to your minimum deposit, you will also need to keep up what is known as a maintenance margin. Basically, once you purchase a stock you will need to make sure that you keep a certain amount of equity in your account. This is usually set at 25% of the total market value of a trader’s securities but it can be higher, depending on the broker you use.
The bottom line
Cash and margin accounts are starkly different and appeal to vastly different traders. If you want to minimize your risk while also minimizing the overall potential of your trading profits, then the cash account option is for you. If you can live with a healthy level of risk while greatly increasing the potential of your returns, then a margin account will suit you.
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