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Brokerage accounts allow you to purchase securities using cash or even by borrowing against your holdings. These two types of accounts are called a cash account and a margin account.
- Cash accounts are fairly straightforward: you select your brokerage firm, deposit cash into your account, and then purchase securities outright.
- In a margin account you will also deposit money and purchase securities, but the brokerage house allows you to use those securities as collateral to purchase other securities on loan. Margin accounts are also often used in the execution of options transactions.
Both accounts allow investors to do different things, and understanding how they operate can help you invest better.
How does a cash account work?
All transactions made in a cash account must be completed with either cash or existing positions. This means the buying of securities is either done with cash that is already in (or will be deposited into) the account, or by the selling of securities that the investor already owns. Cash accounts are a simple way to think about investment accounts – you have the money, you buy the stock.
Sometimes investors can loan out their securities in a cash account via their brokerage firm to other investors or hedge funds, who might be short selling. This process is called securities lending, and many brokerage firms pay the lender a fee for participating.
How does a margin account work?
Like a cash account, investors deposit cash and purchase securities in a margin account. From there, the investor is allowed to borrow against the value of the money or securities in the account for the purchase of more securities or even to withdraw cash.
According to the 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 “minimum margin” or the least amount with which one can open a margin account before trades even take place.
When initiating 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 it means you cannot buy, for example, 70 percent of the purchase price worth on margin. Your brokerage firm can adjust this and might require more than 50 percent of the purchase price be deposited, depending on the riskiness of the security or other factors.
Once securities are purchased, investors are required to keep a “maintenance margin” level of equity. The equity in a margin account is the value of the securities in your account minus the amount you owe (also called the debit balance.) According to the U.S. Securities and Exchange Commission (SEC) rules, investors are required to have a minimum maintenance margin of 25 percent equity at all times.
Your brokerage firm may further adjust the collateral or loan limit and equity necessary.
To use margin borrowing, investors must also pay interest on the margin loan. The rate varies among brokers, but rates are usually on a tiered basis, decreasing as the amount of the loan increases.
So to sum up, an investor with $10,000 in a cash account can buy $10,000 worth of stock. An investor with $10,000 in a margin account can purchase $20,000 worth of stock, using the $10,000 equity as collateral. The broker will then charge interest on the loan.
Benefits of a margin account
A margin account can provide benefits to those who use it, and a margin account is an absolute necessity if you want to short sell, too.
Margin accounts can boost your returns
For the prudent investor, margin accounts can provide huge upside potential. Those who trade in margin accounts are buying larger amounts of securities than they normally would be able to with just their own money. This allows for amplified profits and increased purchasing power. Should you pick the right stock, the upside potential is huge. You keep the profit in a margin account position, less any fees charged by the brokerage house.
Your equity is collateral
One of the biggest benefits to trading in a margin account is the ability to use your own securities as collateral. You already own the equity and do not need to sign new paperwork or loan documents as you would for other types of loans.
Margin accounts are necessary for short sellers
Margin accounts can also benefit short sellers, and brokerages require short sellers to have this kind of account. Shorting a stock means betting against it, or betting that its price will fall. Short selling is essentially borrowing shares from an investor or brokerage firm and selling them. Later the short seller can repurchase the stock, ideally at a lower price. Should the price of the stock decrease, short sellers will profit.
Should the price increase, short sellers must have enough capacity in their margin accounts to cover and sell out of the position.
Margin accounts are subject to margin calls
If you borrow too much money in your margin account, you could run into trouble – what’s termed a margin call. Margin calls occur when there is not enough equity in the account. The brokerage firm will contact you and request that you deposit more money or liquidate some positions to replenish the minimum equity required of the account.
Margin can work well as long as stocks are rising. Let’s assume an investor owns $20,000 worth of securities purchased with $10,000 in cash and $10,000 on margin. The account has equity of 50 percent, the minimum for an initial position. Keep in mind that equity is the total value of the 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 equity of $15,000 in the account ($10,000 original deposit + $5,000 increase in value), or 60 percent equity. But the margin balance still remains at $10,000 (plus any accumulated interest).
But margin hurts the account’s value a lot when stocks are falling. In our example, let’s assume the value of the securities in the margin account now suddenly falls to $12,000. The investor still owes the original $10,000, and the equity remaining in the account is just $2,000.
This $2,000 now represents just 16.6 percent equity of the $12,000 in value of the securities, which will trigger a margin call. When equity falls below the maintenance margin, usually 25 percent, the brokerage house executes a margin call “calling” for more equity in the account. The investor must 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 particularly for securities, where the value of your collateral fluctuates.
- Price swings. Stocks can swing in price from day to day, and trading on margin exacerbates these moves, making your portfolio even more volatile
- Large losses. It is possible to lose more money than you have in the margin account and end up owing more than you originally deposited. Especially if selling short, the amount you owe is at the whim of market swings.
- Forced sales. Brokerage firms can force the sale of the securities in a margin account if their value falls considerably below the required equity.
- Brokers don’t need to contact you. Although most firms will attempt to contact you before liquidating securities as a courtesy, they are not required to contact you in order to sell you out of a position.
Should you open a margin account?
Borrowing in a margin account is risky and should generally be considered only by experienced investors. Due to the inherent risks, a good deal of knowledge is necessary to invest with borrowed money.
Perhaps the most important consideration when trading in 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 the money they could potentially lose.
Potential margin investors should consider whether or not they are in need of a margin account. Margin accounts require active involvement, sometimes every day, especially because of the potential for a margin call.
It’s important to understand what kind of investor you are. If passive investing with slow and steady returns is your goal, then margin accounts might not be necessary for you.
The level of personal market knowledge is also crucial to take into account when considering borrowing on margin. Especially when shorting a stock, an investor needs to know both the stock they are shorting and its surrounding market extremely well in order to place such a bet.
For the right investor, margin accounts can provide a suitable avenue to large profits, but they come with sizable risks. Losing money quickly and the potential forced sales of your securities are some of the risks that need to be considered associated with this kind of trading.