Let’s say you have 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 those 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.
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 A Margin Account Works
Here’s a very basic example. 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 thingy 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 timeframe–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, here’s our list of pros and cons of using a margin account:
Margin Account Pros:
- 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 or trade futures.
Margin Account Cons:
- You can lose more money than you have 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 had 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 know 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.
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