When you open an account with your broker, you will have to pick a cash or margin account. These accounts, both margin and cash accounts come with their benefits and drawbacks. In this article, we will go over both.
Depending on your trading style, choosing an account that fits your needs is an important decision that shouldn’t be taken lightly. Your broker settles trades in a different way on each of these accounts. This guide should make the decision of sticking with a cash account or opening a margin account easier.
Margin and cash accounts are the two main types of brokerage accounts. Margin accounts allow traders to borrow money from their brokers. With cash accounts, all of the orders are made with available cash.
Margin Brokerage Accounts
When trading on margin you are borrowing money from your broker. This allows investors to leverage returns, make additional investments, or for cash flow while waiting for traders to settle. Margin balance is subject to daily interest rate and can be quite high.
Brokers can lend out securities in your accounts to short sellers. This can happen without you knowing.
Margin can be used to make withdrawals as a short-term loan.
With a margin account, traders must keep a margin ratio. If this ratio falls below the limit, you receive a margin call. You can sell some of your securities or deposit cash into your account, to meet this ratio.
Margin is not available on individual retirement accounts due to annual contribution limits. This in turn impacts the investor’s ability to cover margin calls.
Cash Brokerage Accounts
Cash accounts are the most common types of brokerage accounts. Traders can’t borrow money from their broker (trade on margin). The buying power is lower but also limits significant losses.
You pay the full amount for securities with cash by the settlement date. If you don’t have enough cash, this limits the number of trades you can take.
The shares in your cash account can be lent to short-sellers, but only with your permission. This might be an additional source of income. The process is known as securities lending or share lending. Another benefit is that you earn interest (from lending) and profit from upward price movements of the securities.
Lending is not provided by all brokers and might be subject to minimums (either dollar amount or number of shares).
As a margin account investor, you must take into account that your securities may be lent out without notice or compensation. That is if you have a debt (negative) balance on your account. If you don’t use margin, your securities can’t be lent out.
Active traders such as hedge funds are the borrowers of the shares held in a margin account. They borrow securities when short selling or covering a stock loan. Brokerage firms that need underlying instruments for derivates contract (CFDs for example) can also borrow from a margin account.
It is worth knowing, that if shares are eligible for dividend payouts, but are lent out, the investor isn’t the official holder and doesn’t receive real dividends. In this case, payments in lieu of dividends are paid that might have different taxes. If your shares are lent out you might lose your voting rights.
Margin and cash accounts are the two most common types of brokerage accounts. Make sure you are familiar with all the benefits as well as drawbacks before opting for one or the other.