Cash vs Margin Accounts: What’s the Difference?
Broker accounts allow you to buy securities with cash or even by borrowing against your holdings. These two types of accounts are called cash accounts and margin accounts.
- cash accounts are fairly straightforward: you choose your brokerage firm, deposit cash into your account, and then immediately buy securities.
- in one margin account You will also deposit money and buy stocks, but the brokerage house allows you to use these stocks as collateral to buy other stocks on loan. Margin accounts are also commonly used when executing options trades.
Both accounts allow investors to do different things and understanding how they work can help you invest better.
How does a cash account work?
All transactions made on a cash account must be completed using either cash or existing positions. This means that the purchase of securities is done either with cash already in the account (or deposited) or by selling securities that the investor already owns. Cash accounts are a simple way of thinking about investment accounts – you have the money, you buy the stocks.
Sometimes investors can lend their securities in a cash account through their brokerage firm to other investors or hedge funds who may sell short. This process is called securities lending, and many brokerage firms pay the lender a fee to participate.
How does a margin account work?
As with a cash account, investors deposit cash and buy securities in a margin account. From there, the investor can borrow against the value of the money or securities in the account to buy more securities or even withdraw cash.
Under Financial Industry Regulatory Authority (FINRA) regulations, investors are required to deposit with their brokerage firm the lesser of $2,000 or 100 percent of the purchase price of the securities. This is the “minimum margin” or the smallest amount one can open a margin account with before any trades even take place.
When entering into a position, investors can borrow up to 50 percent of the purchase price of the securities to be purchased on margin. This is called initial margin and means you can’t buy, say, 70 percent of the purchase price as margin. Your brokerage firm can adjust this and may require a deposit of more than 50 percent of the purchase price, depending on the risk of the security or other factors.
Once securities are purchased, investors must maintain a “conservation margin” of equity. Equity in a margin account is the value of the securities in your account minus the amount you owe (also called the debit balance). Under US Securities and Exchange Commission (SEC) regulations, investors must have a minimum safety margin of 25 percent equity at all times.
Your brokerage firm may further adjust the collateral or loan limit and required equity.
In order to use margin loans, investors must also pay interest on the margin loan. The interest rate varies between brokers, but interest rates are typically tiered and decrease as the loan size increases.
In summary, an investor with $10,000 in a cash account can buy $10,000 worth of stock. An investor with a $10,000 margin account can buy $20,000 worth of stock and use the $10,000 equity as collateral. The broker then calculates interest on the loan.
Benefits of a Margin Account
A margin account can bring benefits to those who use it, and a margin account is an absolute necessity if you also want to short sell.
Margin accounts can increase your returns
For the prudent investor, margin accounts can offer tremendous upside potential. Those who trade on margin accounts buy larger amounts of securities than they normally could with just their own money. This allows for increased profits and increased purchasing power. If you pick the right stock, the upside potential is huge. You keep the profit in a margin account, minus the fees charged by the brokerage house.
Your equity is a security
One of the biggest benefits of trading with a margin account is the ability to use your own securities as collateral. You already own the equity and don’t have to sign any new paperwork or loan documents like you would with other types of loans.
Margin accounts are necessary for short sellers
Margin accounts can also benefit short sellers, and brokers require short sellers to have this type of account. Shorting a stock means betting against it, or betting that its price will fall. Short selling is essentially borrowing stock from an investor or brokerage firm and selling it. Later, the short seller can buy back the stock, ideally at a lower price. If the price of the stock falls, short sellers profit.
Should the price rise, short sellers must have enough capacity in their margin accounts to cover and sell the position.
Margin accounts are subject to margin calls
If you borrow too much money in your margin account, you could get into trouble – known as a margin call. Margin calls occur when there is insufficient equity in the account. The brokerage firm will contact you and ask you to deposit more money or liquidate some positions in order to replenish the minimum capital required for the account.
Margin can work well as long as stocks are rising. Let’s say an investor owns $20,000 worth of securities that he bought with $10,000 in cash and $10,000 of margin. The account has 50 percent equity, the minimum for a starting position. Remember that equity is the total value of securities and cash in the account minus the margin loan.
Let’s say the value of the underlying position increases to $25,000. The investor now has $15,000 equity in the account ($10,000 initial deposit + $5,000 appreciation), or 60 percent equity. But the margin balance still remains at $10,000 (plus any accrued interest).
But the margin hurts the value of the account badly when stocks fall. In our example, let’s say the value of the securities in the margin account suddenly drops to $12,000. The investor still owes the original $10,000 and the equity remaining in the account is only $2,000.
That $2,000 now represents only 16.6 percent of the equity of the $12,000 worth of securities, triggering a margin call. When equity falls below the minimum margin, typically 25 percent, the brokerage house makes a margin call that “calls” to get more equity in the account. The investor needs to deposit cash or sell some positions to restore the minimum equity.
Risks of a Margin Account
Margin accounts come with inherent risks that cannot be overlooked. Borrowing money for anything is a risk, but especially for securities where the value of your collateral fluctuates.
- price fluctuations. The price of stocks can fluctuate from day to day, and margin trading amplifies these movements, adding even more volatility to your portfolio
- Big losses. It’s possible to lose more money than you have in the margin account and end up owing more than you originally deposited. Particularly in the case of short sales, the amount owed depends on market fluctuations.
- forced sale. Brokerage firms can force the sale of securities held in a margin account if their value falls significantly short of the required equity.
- You do not need to contact brokers. Although most firms will attempt to contact you before liquidating any securities, they are not required to contact you in order to sell you from a position.
Should You Open a Margin Account?
Borrowing in a margin account is risky and should generally only be considered by sophisticated investors. Because of the inherent risks, a lot of knowledge is required to invest with borrowed money.
Perhaps the most important consideration when trading on a margin account is determining how much you are willing to lose. Margin investing is risky and investors should have considerable knowledge of what they are investing in and how much money they could potentially lose.
Potential margin investors should consider whether or not they need a margin account. Margin accounts require active participation, sometimes every day, especially because of the possibility of a margin call.
It is important to understand what type of investor you are. If passive investing with slow and steady returns is your goal, margin accounts may not be necessary for you.
Level of personal market knowledge is also crucial when considering lending on margin. In particular, when shorting a stock, an investor must have a very good understanding of both the stock they are shorting and the surrounding market in order to place such a bet.
For the right investor, margin accounts can be a viable route to big profits, but they come with significant risks. Losing money quickly and being forced to sell your securities are some of the risks to consider in this type of trading.