When you first open a brokerage trading account, you will be given two choices to choose from. Margin vs Cash accounts. Your choice can affect your trade strategy, especially if you are day trading and subject to the pattern day trader (PDT) rule. This guide will discuss the account differences so you can make the best choice for your trading style.
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Is Margin the Same as a Cash Account?
Margin vs cash accounts are not the same. Cash accounts require you to use the available cash in your account to trade. Whereas margin accounts let you borrow money against what’s in your account to trade.
If you’re new, you only want to be trading with a cash account. Borrowing against your account when you’re unsure how to trade is the best way to blow up your account. And that’s something you don’t want to do.
Cash
A cash account is easier to understand. Unlike a margin account, you’re only trading with the money you have. You can’t borrow funds from your broker. The best part of this account type is that you can prevent substantial margin trading losses.
But you don’t have the same purchasing power for higher leverage. The pattern day trading rule does not limit cash accounts. So an account under $25,000 will be able to day trade.
And you will never receive a margin call since you aren’t using margin and won’t owe anything.
With a cash account, you must wait for cash settlement before you can place a trade. And the trade must also settle before cash can be withdrawn when shares are sold.
If you make a day trade and profit by $1,000, the money from the trade will not be available for use or withdrawal for a few days.
Cash accounts can not be used for shorting stocks, nor can your shares be lent to short sellers with a cash account.
Cash Account Examples
- You buy a stock for $100; it goes to $150 you make a 50% profit.
- You buy a stock for $100; it drops to $50 you have a 50% loss.
Margin
Margin accounts give you the ability to borrow money from your broker, helping you amplify your buying power.
Because your broker is lending you funds using your account as collateral, additional requirements are needed to open a margin account, and most accounts require a fee for margin use.
Depending on the broker and your account size, up to 50% of a purchase can be made with margin.
But you don’t have to use this much; 10% or another amount up to 50% is fine. If you have $20,000 in your margin account, you could buy up to $40,000 in assets, but margin increases your level of risk.
You are allowed to borrow and short assets, and your broker can lend out your shares to short-sellers. Just make sure you’re really good if you’re not using your money to trade.
Margin Account Examples
- You buy a stock for $100, using $50 of your own money and $50 of margin from your broker. The stock rises to $150, and you have a 100% return on your $50 investment less the brokerage fees and margin interest.
- You buy a stock for $100, using $50 of your own money and $50 of margin from the broker. The stock drops to $50, and you have lost 100% of your investment, plus brokerage fees and margin interest.
We can see the ability to gain and lose with a margin account is greater. Margin can be very helpful if you meet the PDT rule and know what you are doing.
Note Due to their higher risk, penny stocks, IPOs, and OTC Bulletin Board stocks can not be traded with margin.
Should Beginners Use Margin or Cash Accounts?
If you’re a new trader, a margin account could get you into trouble. Borrowing money as a new trader, or overtrading are both pitfalls for the new trader which margin accounts can lead to both. Therefore, a cash account is all you need. Once you practice, you can then begin to look into margin accounts. But you don’t want to lose your brokerage account before you can grow it.
Maintaining Margin
All margin accounts have maintenance requirements; the minimum amount of equity that must be kept in the account.
If the equity drops below the minimum required, the brokerage will issue a margin call requiring more cash or securities to be added to the account by a specific date. When required, a broker may sell holdings without notice to prevent further losses
Short Sales
Most margin accounts will allow shorting of stocks. With short selling, a trader borrows shares from their broker and sells them to a long holder with the intention of buying them back at a lower price and returning the borrowed shares to the broker, profiting from the price decrease. Short selling usually has a fee over and above the interest charged for borrowing shares.
Opening Margin Accounts
Opening a margin account will have more requirements than a cash account. In the U.S., there is a federal required $2000 minimum deposit, with some brokers requiring more. Brokers will perform a credit check to confirm your worthiness and want to know about your income and assets.
Summary
Choosing between a cash and margin account is an important one. Your buying power, ability to day trade, and gains or losses can be amplified, depending on your choice. Don’t make a hasty decision; choose the best account by considering your trading style, strategy, and available funds. For most, a cash account will be satisfactory. For the trader seeking superior returns, who will closely monitor their positions, the margin account may make more sense.
