Cash vs Margin Brokerage Accounts
Cash vs. Margin Brokerage Account
Tap below to watch a video rundown on the two main types of brokerage accounts, and read on for more details.
There are different types of accounts available for everyday investors, depending on what your needs and objectives are. When you open a brokerage account, you’ll likely need to decide whether you want to open a cash account or a margin account.
Cash accounts are the most conservative choice for investing real money in a brokerage account. Cash accounts don’t permit any borrowing of money (trading on margin) from a broker or financial institution.
With this type of brokerage account, the full amount of your investment plus the stipulated commission must be paid in advance of completing a transaction. This means you’ll need to pay for any trades in cash by the required settlement date. "Settlement" is the official transfer of the securities to the buyer's account and the cash to the seller's account. As a rule, the trade settlement date is 2 business days after the transaction. That is, if you purchase a security on Monday, the transaction will settle on Wednesday.
If you plan to trade on a cash basis, there are 3 types of potential violations you should try your best to avoid: cash liquidations, good faith violations, and free riding.
- A cash liquidation violation occurs when you buy securities and cover the cost of the purchase by selling other fully paid securities after the purchase date. The brokerage industry requires that you have sufficient settled cash in your account to cover any purchases on settlement date.
- A good faith violation occurs when you buy a security and sell it before it was ever paid for with settled funds.
- A free riding violation occurs when you purchase securities and then pay for that purchase by using the proceeds from a sale of the same securities. Doing so is a violation of the Regulation T of the Federal Reserve Board concerning broker-dealer credit to customers. You need to pay for the stock in full before selling it, and also make sure you don’t pay for the purchase, even partially, with proceeds from the sale of this very stock.
To sum up, active traders need to be fully aware and stick to cash account trading rules and maintain sufficient settled funds to pay for purchases in full before settlement dates.
Margin accounts are brokerage accounts where a broker lets the customer borrow money to make an investment. It allows you to buy more stock by using your current investments as collateral against the funds borrowed from your brokerage. The amount of collateral that you are required to have is called the margin requirement.
Margin accounts carry more risks than cash accounts. If the value of the stock drops significantly while you hold it using margin, you'll will be required to deposit more cash, more marginable securities, or sell a portion of the securities to maintain the minimum margin requirements.
It’s still possible to trade with your own cash in a margin account. Unlike with cash accounts, trading in a margin account would allow you to use unsettled funds without settlement date related violations.
In addition, certain trading behaviors, such as short-selling and day trading, are allowed only in margin accounts.
By using borrowed funds, investors have the opportunity to leverage their gains. This means that the investor’s return on investment will be better than the cost of borrowing money. While this sounds like a great deal, investing on margin also comes with significant risks.
When a margin investment goes against you, you will risk not only losing your initial investment, but also the funds borrowed on margin. If your stock prices drop so far that your collateral no longer covers your borrowed money, you will need to find more money to use as collateral.
The securities in your margin account may be lent out to another party or used as collateral by the brokerage firm at any time without notice or compensation to you if there's a debt balance (negative balance) on the account where you've accessed the margin funds.
In order to be eligible to trade on margin, an investor must establish a margin account with their broker. Most brokerages require an initial investment of at least $2,000.
After setting up a margin account, an investor can buy stock by paying cash in full or purchase a stock using margin, where the brokerage will pay up to 50 percent of the purchase price.
Since buying on margin is the same as borrowing, the amount of margin used to purchase stock is subject to interest payments, just like any other form of borrowing. Also, strict requirements need to be satisfied to maintain a margin account.
To sum up, trading in a margin account provides you with more flexibility and leverage for your investments and a possibility of better returns, but it's also much riskier than trading in a cash account.