When you go to open a brokerage account, you will be asked if you want a cash account or a margin account. There are many differences between the two, so you need to know them to choose the right account type for your use case. Margin accounts allow investors to make money as a loan to invest and trade. As a whole, the monetary requirements are the major differences between the margin account and the cash account. Let’s understand Cash Account Vs Margin Account.
What is a Cash Account?
The functioning of a cash account is straightforward. The transactions in this type of account must be entirely made in cash or long positions. To trade, investors must deposit cash into the account and then sell off the existing trade at the end of the trading hours. The cash received from that will be able to settle the buy orders.
Provided you permit the brokerage firm, you can give the shares in your cash account as a loan to short-term or hedge investors. You can get additional earnings from this credit-giving. Depending on the demand your shares have in the market, the buyer may quote a price for you to lend the shares to them. Note that when you permit the brokerage firm, they may lend at a higher rate.
For instance, they may loan your highly-demanded shares at 13% and you might receive less than that, say 8%. Nevertheless, this is a good source of additional income. Of course, there is considerable demand for this to work in the market especially from hedge-fund investors and short-sellers. When they do borrow securities or capital from you, they have to pay you certain fees and interest on the amount borrowed. But the fees and the interest rates vary with the position and performance of the market.
As a whole, complex and advanced forms of investment are not available when you have a cash account. For instance, you will not be able to do Futures trading since it requires margins. Although Options trading can be done on cash accounts, it is harder to implement options contracts. You need to have enough cash for you to be able to exercise your options.
As a whole, think of cash accounts this way, you always need to have funds pre-deposited in your account to be able to buy any share.
What is a Margin Account?
Through the margin account, you can borrow money against the assets in the account to do short-selling or purchase new shares. Investors prefer using the margin account when they want to fully take advantage of the bearish and bullish movements in the market. As an investor, you can also use margins to withdraw direct cash and this will act as a short-term loan.
In many cases, margin accounts allow you to borrow around half the purchase price of the investments you want to make.
For example, if you have $5000 in your brokerage account and you want to buy a stock that costs $100, you will be able to buy exactly 50 stocks if you had a cash account. But through a margin account, you can buy 100 stocks by taking the remaining $5000 as a loan. Of course, since the amount, if given to you as a loan, there will be an interest associated with it that the broker will charge.
Margin accounts are useful when you need to purchase stock immediately but the cash may not get credited into your account for a few days. Similarly, if you want urgent cash from your brokerage account but it does not have enough balance, you can take the short-term loan only through a margin account. Even in Futures and Options trading where there is quite a risk of loss on initial investments, margin accounts can be a better option.
Note that the margin accounts must maintain a ratio of margin at all times. If the account does not maintain it, you will be given a margin call. Then, you have to deposit more securities or cash to be able to eliminate the margin call. You can even sell some of the investments you have to raise cash to bring the account within the margin ratio.
Cash Account Vs Margin Account: Risk Factor
The risk associated with cash accounts is typical, based on what the security actually is. For example, if you have invested in a stock of $1000 and the value of it falls by 20%, you lose $200 in the valuation.
In the case of margin accounts, the losses are more because you would have borrowed more money to invest in that stock. For example, if you had invested $1000 on a stock and borrowed another $1000, to invest a total of $2000, and the value fell by 20%, you ultimately lost $400.
Although you can argue that margin accounts help increase incomes, any small risks or downside in the market can be magnified and can be disastrous. Note that, you will still have to pay back the loan amount with the interest, so there is always going to be extra stress on your portfolio to perform better.
Even the most established and stable companies in the market can go through a really bad market fall. Take the example of Berkshire Hathaway which has had price drops in the range between 40% to 60% in history. According to Warren Buffet, these price drops are one of the biggest arguments against borrowing money for stocks. Not only will it affect your portfolio but it will also affect you mentally seeing the scary plunges and headlines. This unstable mind may make even more bad and impulsive decisions.
Differences Between Cash Accounts and Margin Accounts
|Parameter||Cash Accounts||Margin Accounts|
|Trading Capacity||The trading capacity is limited only to the cash deposited in the account||The investor may also borrow money to invest and trade|
|Risk||The risk associated with cash accounts is usually only with the security purchased and therefore, the risk is conservative||Apart from the risk of the invested or traded security, investors have to bear the risk of fulfilling the amount borrowed along with the interest. Therefore, the risk is aggressive|
|Securities Ownership||The securities in your account will only be in your possession||The securities in your account can be loaned out by your brokerage|
|Investment and Trading Opportunities||The securities that you can trade on stocks, bonds, mutual funds, index funds, REITs, exchange-traded funds, cryptocurrencies and a few Options trades||Apart from all the securities you can invest through cash accounts, you can also invest in advanced Options trades, Futures, forex and short selling|
|Investment and Trading Strategies||The strategies that traders typically use through cash accounts are long and covered options||Due to the higher flexibility, investors may implement advanced trading strategies naked options, short, long etc.|
|Regulatory Requirements||There are no regulatory rules for how much you can trade on your account (except for the transaction limits of course)||There are certain minimum regulatory requirements such as depositing a minimum amount with the brokerage and meeting an initial margin requirement. Apart from this, you will need to maintain a minimum equity in your brokerage account throughout|
Final Thoughts: Cash Account Vs Margin Account
These are the biggest differences between a cash account and a margin account. Before you decide to set up a brokerage account, you need to understand your goals and styles with investments. Post that, you should be able to pick the right one between the two. Note that this decision will highly influence how your investment journey will span out in the future.
Frequently Asked Questions
When to choose cash accounts?
It is best if you are just beginning as an investor. Of course, there are risks associated with losing the money you deposit and trade on your cash account, it is straightforward. For beginners, it will be easier to control the risk.
When to choose margin accounts?
If you have experience in managing risk and want to make the most of the ups and downs in the market, margin accounts may be the better option. You should have a profound understanding of how to understand charts, business fundamentals, and margin trading. Without being sure, you may commit mistakes that might prove costly.
What are the interest rates on the amount loaned from your margin account?
It depends on the brokerage firm. Check the documentation before you proceed to open your account with the firm.
What is a margin call?
It happens when the value present in the brokerage account of the investor falls below the minimum requirements set by the broker. If this happens, the investor must deposit more money or sell some assets already present in the account
What can you not do with a cash account?
You will not be able to do short-selling and margin-selling through the cash account.