An article exploring the differences of each type and which you should get as an investor
To begin your journey as an investor, you're gonna need an account with your brokerage. Think of this account as the springboard from which you can move your finances around and actually begin the long but fruitful work of trading.
As you start though, you need to decide what kind of trader you want to be, specifically. The nature of investments you want to make will determine whether you should open a cash account, margin account, or both.
Knowing from the beginning which one you need won't only save you costs, but also allow you to better formulate your strategy for trading in the coming months at least.
Margin Account vs Cash Account: What’s The Difference?
With a cash account, you have to put your full investment up front and won't be able to withdraw or trade with what's in the account until you've met some conditions set by the brokerage. In a margin account on the other hand, you're allowed to borrow against your assets in order to purchase additional investments that can increase the potential returns of your holdings. But there are also associated risks involved as well that could result in losses for you if something goes wrong with your trades.
To determine which is better suited for your needs as an investor will really come down to how much money you have available for investing initially. If it's not enough then opening a cash based account would be ideal since it won't require you to borrow money for your investments.
You may have heard about margin calls, and if you're not careful that could wipe out everything in your cash account with just one trade gone bad. Your risk tolerance will also play a role in whether or not you should open a margin account as well since the nature of this type of trading means that you'll be taking on more risk than usual when compared to the traditional cash based option and only traders who are looking to make more aggressive moves should consider it.
In addition to helping you decide which kind of account is better suited for your investing needs, there are also other differences between these two options based on how they work that can help you determine what would be best:
- Cash accounts require no minimum balance to open a trading account. Cash accounts require that you meet certain conditions for any withdrawals before they'll be made available by the brokerage.
- A margin account requires initial investments of at least $2,000 to open an account. Margin accounts allow you to make withdrawals anytime if you aren't over extended, so long as it doesn't exceed the legally allowed amount.
Cash based accounts don't charge additional fees on top of those charged from your broker, but margin accounts generally have higher fees associated with them since investors are required to borrow money from their brokers in order to trade with it.
Consistent and frequent traders should consider opening a cash based account because the interest rates charged by their brokers on margin loans can start taking a large portion of their profits. A cash based account is the only option that allows you to invest in mutual funds and stocks from other countries, which can be beneficial for those who are looking to diversify their investments with foreign holdings or try out different products and services that aren't available domestically.
Margin accounts typically allow investors to make more transactions per month than a cash account since there will probably be less restrictions on how many times you can buy and sell securities over a set period of time.
Basically, if your cash balances are low enough then it doesn't really matter too much if you're using margin trading as opposed to putting more money into loans and interest rates at this point--you'll still end up paying them one way or another since you have no other option at the moment. But if you're sitting on a much larger balance then evaluating your risk tolerance and any additional costs in fees that you could incur from margin trading are going to be keys points for consideration if you want to start moving money around more often as it will save time and money in the long run over using a cash account.
On the other hand, if you've got enough saved up already but don't feel comfortable making all of your investments with such a large amount then it would probably be better to have some extra funds available to make trades based on what's going on in the market right now. This also comes down to how much confidence you have in yourself as an investor since you'll need to be willing to take on a bit more risk in order to be able to capitalize on any market moves that you see.
So these are the main differences between a cash based account and a margin account , but there's one last thing that I wanted to cover before I wrapped up here, which is whether or not it's better for your investing goals if you decide to make the switch from using a cash account over to a margin account.
These are the usual accounts dealt with by the majority of investors. They are the kinds that facilitate the buying and selling of stocks, any and all transactions that require cash or liquid funds or allow the investor to set up a long position with stocks.
When buying securities in a cash account, you either have to deposit cash to settle the trade or sell an existing position on the same trading day so cash is freed up and available to settle the buy order.
In essence, there's very little difference between cash accounts and the regular savings accounts one opens with a bank for daily expenses.
One simply opens a Cash Account to use his or her money to buy and sell securities in the market -- along with benefiting from a host of services and incentives the specific brokerage might offer too.
If you have stocks that are more volatile or work best for short positions, then you can ask the brokerage for permission to lend them out. Lending out stocks to investors or hedge funds looking to set up short positions is a great way to earn passive income from idle, cheap, or potentially depreciating stocks.
As stated, cash accounts are used by investors who are looking to take up more long positions or long selling than they do short positions or short selling. Though investors can engage in both kinds of selling, one cannot short sell using a cash account.
Cash accounts are best used when the investor wishes to make investments with stocks predictably in a bullish market. A bull market is one where stocks are rising or about to rise in value. It is the opposite of a bear market where the value of stocks is decreasing.
When an investor with a bullish attitude takes a long position with stocks, he or she is buying stocks with the belief that they will rise in value -- essentially the common understanding people have about stock investment.
For example, you hear on the news that ABC Company is planning to expand operations globally and even to untapped markets in developing nations. This endeavor will take at least a few years to actualize and, currently, the stocks are still cheap.
You predict that the stock value will eventually double or even triple when they begin to expand and, thus, buy the stocks right now to go long.
Of course, there are different types of long position investments and, more often than not, the term is merely a reference to the length of time with which an investor commits to an investment.
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Where a cash account allows you to buy and lend out stocks, a margin account allows you to borrow stocks or buy positions.
They are very handy and cost-effective if experienced investors know how to use them. Using margin accounts, lets you engage in short selling and find ways to benefit from bullish or bearish markets alike.
Margin can also be used to make cash withdrawals against the value of the account in the form of a short-term loan -- meaning if you have $1000 deposited in the account, you can also borrow up to 50% or $500 as a short-term loan.
Though most investors borrow around 10-20% of their account's value online and these are usually used to buy even more securities than one would with a simple cash account.
The trade-off with that though is that short selling is extremely risky and, unless you're able to make correct predictions more than wrong ones, a margin account can be very costly in terms of fees and interests.
Another thing one has to consider is that margin accounts have a limiting ratio of the amount of cash deposited and the amount of cash borrowed. When this ratio is upset, the brokerage can issue a "margin call" which is a request for the owner of the account to deposit more cash to maintain the allowed ratio.
This means that margin accounts also require much more attention than cash accounts as you need to make certain your securities are covering all the expenses entailed with the account. Though in the right hands, margin accounts let you leverage positions and hedge against unfavorable markets.
Where investors mainly use cash accounts to take long positions with stocks, most investors open margin accounts to be able to engage in short selling. Short selling allows an investor to profit from a volatile market and a company's expected depreciation.
Short selling occurs when an investor predicts a certain stock to be overvalued and believes the price will eventually fall. Using a margin account, the investor will borrow the stocks he or she believes are overpriced and sell them at their current market value.
When the prediction is proven correct and the price of the stocks plummet, the investor then buys the stocks back. The difference between the price the stocks were sold for and the price they were bought back is the profit the investor earns. The act of borrowing the stocks an investor believes will depreciate is called "going short" or taking a "short position.
For example, you believe that the stocks of ABC Company are overpriced at $5 per share and believe that soon the real, lower value of the stocks will be reflected.
You decide to try and benefit from this and proceed to use your margin account to borrow 100 stocks from ABC Company -- amounting to $5000. After borrowing them, you proceed to sell them at their current price in the market.
After a short time, your predictions come true and the price of the stocks of ABC Company fall to $2 per share.
You proceed to buy the 100 back at this price -- amounting to about $2000. Since you originally sold the 100 borrowed stocks for $5000 and bought them back at only $2000, the difference -- $3000 -- is the profit you realized.
Though it allows you to benefit from a bearish market, the practice is extremely risky and must only be done by investors with a high-risk tolerance.
Predictions can turn out to be wrong and the prices of the stocks might increase faster rather than depreciate. In such cases, unless you run the possibility of incurring loss or, worse, owing to the brokerage money for the stocks you borrowed.
How to Choose?
The decision of whether to get a cash account or margin account should not be seen as a decision at all. The truth is, some brokerages do not even provide margin account options -- due to their risk -- and most only allow margin accounts to be opened if the investor already has a cash account existing with the firm in good standing.
Instead, see both as part and parcel of your investment journey.
As you begin, a cash account is most likely the one you're gonna start with. Testing out your strategies and knowing how much risk is acceptable to you will give you a hint whether or not you need a margin account.
Most investors are happy with a cash account and make a decent living using only that. Some though do not want to miss out on the opportunity to earn higher or hedge against market volatility -- making a margin account necessary to engage in the investments geared towards such purposes.
Like with any form of investment, a cash or margin account is only as good as the strategy of the investor who owns them.
Knowing when you intend to engage in short selling, how many long positions you wish to take, and how much money you have to move around are the things that you should decide upon as early as now.
Cash and Margin accounts are simple financial tools that investors use to carry out their strategies. They are, in essence, the starting point from which your strategies and know-how proceed to either make or cost money.
Due diligence and research are necessary with all kinds of investment and financial instruments.
The name of the financial game is knowledge and the more you have it, the more likely you are to earn from all the market has to offer.
This is why I believe that learning about margin trading makes good sense.
Cash and Margin Accounts are used in other areas of life as well, besides the stock market. The difference between the two accounts is where you must put your own capital - cash or margin. Cash means your money; margin means you're putting it at risk with a broker who loans you funds to buy on leverage through what's called "margin," which is simply borrowing against the security.
For example, if an investor puts up $10,000 in cash to purchase $100,000 worth of securities (that will cost them $110,000), they have a 10:1 ratio ($100k/$10k). That will be a large investment when applying for margin.
The SEC regulates and oversees the U.S. securities markets, including brokerage houses like Scottrade. The governing body sets high standards of conduct and practice within the financial services industry to protect investors from fraud as well as illegal or unethical practices by brokers, dealers, investment advisors and their associated persons. With that said there is also a set of Securities Exchange Commission regulations (SEC) that every investor must know before making any investment in stocks or bonds.
For starters, if you don't understand margin trading please review this article on Margin Trading Basics . Even better would be to contact your broker directly or visit their website for additional details and information on margin trading rules and procedures.
Read the fine print before signing up! You'll be glad you did when you're not caught by fine print that can cost you a lot of money.