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Margin Account vs. Cash: Which is Better for You?
In this post, we’ll look at the key differences between a margin account and cash account, and help you determine which one might be the better choice for you.
For example, let’s say you’ve decided to start trading stocks. You’ve read some tutorials and watched some videos …
You’ve set your short-term and long-term goals, and you’ve drafted your trading plan and strategy …
You know how much money you can afford to lose without losing your shirt …
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Then, you’ll need to open a brokerage account to start trading stocks. Typically, the brokerage you’ve picked will ask you if you want to open a cash account or a margin account.
Both accounts will allow you to trade securities, but — there are huge differences in the ways these two accounts work, what types of market transactions you can make with them, and how much money you need to invest.
Oh, and how much you could lose, of course.
So, Let’s start at the beginning …
- A cash account, as the name suggests, is a type of account in which you pay the full amount for the stocks you buy.
- A margin account, on the other hand, is an account for which your broker lends you money to buy stocks. The brokerage uses your account as collateral for that loan, on which you owe interest to your broker.
With a margin account, you can borrow from your broker up to 50 percent of the purchase price of securities that can be purchased on margin. If you have a margin account, you can short stocks, or trade futures and options—things you can’t do with a cash account.
So before you decide whether you want a cash account or a margin account, take a look first at your investment and trading strategy and your risk tolerance.
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How It Works
- You buy a stock for $5.
- The stock’s price rises to $7.50.
If you bought that stock in a cash account, that is — paid in full — then you have a 50 percent return on your investment.
If you bought that $5 stock on margin, you paid $2.5 for it in cash and the other $2.5 you borrowed from your broker. So, when the stock rises to $7.5, you get a 100 percent return on your $2.5 invested (not counting the interest you owe to your broker).
However, the tricky thing with margin accounts is that percentage losses are steeper if your trade goes against you.
If that $5 stock drops to $2.5, in a cash account you would lose 50 percent of your $5 investment, but in a margin account, your loss is 100 percent of your $2.5 investment … and you’ll still owe interest to your broker for the loan.
In margin accounts, brokers have what’s known as a maintenance requirement. This is the minimum amount of equity you must keep in your margin account at all times.
The equity in your margin account is the value of your securities minus how much you owe to your broker.
If your account drops to below that maintenance requirement, your broker will make a margin call and will ask you to deposit more cash or securities in your account within a specific time frame — usually a few days.
If you fail to do this, your broker will sell your securities and take what you owe out of the proceeds.
In margin accounts, your broker may be able to sell your securities at any time without consulting you first, and without notice.
Now that we’ve covered the basics, let’s dive a little deeper into some of the interesting things you can do with a margin account …
If you want to take advantage of a stock moving lower you can look to short the stock. This involves borrowing shares from a broker, selling them and then hopefully buying them back lower to return them to the broker.
If you’ve made a good trade, and you’ve bought the shares at a lower price, whatever the difference between the price you sold and bought at will be your profit (minus commissions and fees).
Since shorting involves the borrowing of shares, you’ll need to have a margin account set up first.
Be warned: There are normally fees involved in shorting stocks in addition to the interest you’ll have to pay, so make sure you do your research!
Stocks generally make their biggest moves over a period of weeks, months, or even years.
The movements of a stock in a single trading day are often of a much smaller size.
If you’re looking to trade these intraday movements and make the same amount of money as a longer-term trade, you’ll often have to hold more shares. Thus, you’ll have to have more funds in your account.
This is where a margin account can help you to maximize your profits day trading.
By using a margin account, you’ll be able to hold double the amount of your funds in open stock positions, which could potentially increase your day trading profits, but also, increase your losses – be careful!
Advanced Options Strategies
Not all options trading strategies are equal.
Some basic options strategies, such as buying call contracts don’t require margin as you’re purchasing the option contract outright.
When you start dealing in strategies where you have a potential future liability, such as selling puts, you’ll need more than a basic cash account.
Brokers define options strategies across five different levels, depending on the risk of the strategy.
Levels one and two are low risk and can be used with a cash account, but anything higher than that means you’ll need a margin account.
The simplest form of pair trading involves buying a stock and then shorting another stock that the first stock is closely correlated with — buying the strong stock, selling the weak stock.
A basic example of this is going long $10,000 worth of Coca-Cola and going short $10,000 worth of PepsiCo.
With this strategy, the trader is attempting to profit from the difference in price moves between the two correlated companies, rather than make an outright directional trade on either stock.
For example, the market could drop 20% overall, but as long as Coca-Cola declines less than PepsiCo, the trader will have possibly made a profit (assuming it’s more than commissions and fees).
This is one of the more exciting strategies a margin account could allow.
Opening a Margin Account
A regulated brokerage can’t simply allow just anyone to open a margin account. There are various hoops you have to jump through before they let you open an account, but they’re not too tough.
First, you’ll need to make sure you have at least $2,000 to deposit as this is the federally required minimum account size. Some brokers require more.
Your broker will also check your credit rating and you’ll have to provide them with information about your assets and income for them to assess.
All of the jumping through hoops may seem a bit tedious, but you’re effectively asking to be allowed to borrow certain assets. Think of it somewhat like applying for a car loan or credit card.
What do we Recommend Next?
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The Final Word
This post hopefully helped give you an idea of which type of account might work better for you.
Trading on margin comes with many exciting possibilities, but there are plenty of risks you need to be aware of. Make sure you know what you’re doing!
Here’s a quick recap of the pros and cons of trading with a margin account:
- You get more purchasing power to boost your returns.
- You can take advantage of stock prices today, even if you don’t have enough cash on hand.
- You can short stocks with a margin account
- You can lose more money than you invested.
- You may have to deposit extra cash or stocks into your account on short notice.
- You may be forced to sell a part of or all of your securities in your account if declining stock prices reduce the value of your account.
- Without consulting you, your brokerage firm may sell some or all of your stocks to pay off the loan it extended to you.
- Your broker charges you interest for borrowing, so you must know and calculate how that affects your returns.
That’s not necessarily the full list of the perks and risks of using a margin account, but now you have a better idea of the main differences between a cash account and a margin account, how they work, and how to protect yourself from risks.
Read your margin agreement carefully before you sign up. Always do your homework. Be informed and stay informed.
Pick the account that best suits your trading goals, strategies, risk tolerance, and limits on how much you can afford to lose.
No matter what, only take good trades. If you want to make finding those good trades easier, StocksToTrade will help you with all your charting, newsfeeds, watchlists and more. Grab the 14-day, $7 trial now!
Do you trade on margin? Why or why not? Share your comments below!
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