Margin vs Cash Accounts

Margin vs Cash Accounts Day Trading

When you open a brokerage trading account, you will be given two choices—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.

Margin vs cash accounts are not the same. Cash accounts require you to trade the available cash in your account. Meanwhile, margin accounts let you borrow money against what’s in your account to trade.

You only want to trade with a cash account if you’re new. Borrowing against your account when unsure how to trade is the best way to blow up your account. And that’s something you don’t want to do.

Cash Account Explained

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 placing 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 And the trade must also settle before cash can be withdrawn when shares are sold.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 Example

  1. If you buy a stock for $100, which goes to $150, you make a 50% profit.
  2. If you buy a stock for $100 and it drops to $50, you have a 50% loss.
Margin Account Example

Charles Schwab Website

Margin Account Explained

Margin accounts allow you 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 a 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 can borrow, and short assets and your broker can lend out your shares to short-sellers. Just ensure you’re really good if you’re not using your money to trade.

Margin Account Example

  1. 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.
  2. 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, brokerage fees, and margin interest. 

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 a margin. 

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Should Beginners Use Margin or Cash Accounts?

A margin account could get you into trouble if you’re a new trader. Borrowing money as a new trader or overtrading are both pitfalls for the new trader, and 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. 

If the equity drops below the minimum required, the brokerage will issue a margin call requiring more cash or securities added to the account by a specific date. A broker may sell holdings without notice to prevent further losses when required. 

Short Sales

Most margin accounts will allow the shorting of stocks. With short selling, a trader borrows shares from their broker and sells them to a long holder to buy them back at a lower price and return 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. 

Margin vs Cash Account Risks

1. Potential for Unlimited Losses

Due to leverage, losses can be unlimited in margin trading accounts. Leverage allows traders to control a larger position with a smaller amount of their own money. While this can amplify gains, it also magnifies losses.

Investors borrow funds from their broker to increase their buying power when trading on margin. If the price of the securities being traded moves against the trader’s position, the losses on the borrowed funds can exceed the initial investment made by the trader.

Margin Trading Loss Example

Suppose a trader deposits $10,000 into their margin account and uses it to purchase $20,000 worth of AMD. To do so, they borrow the remaining $10,000 from their broker. For whatever reason, if the price of AMD drops by 50%, their account equity will drop to $5,000. In this scenario, not only has the trader lost $5,000 of their initial investment, but they would also owe the broker the $10,000 they borrowed. This demonstrates how losses can exceed the trader’s original investment, resulting in unlimited losses.

2. Margin Interest Debt

Like paying interest on your mortgage, any loan you take out on margin also incurs interest. Let’s say you have a margin trading account with a broker and decide to borrow $10,000 on margin to purchase stocks. Your broker charges an annual interest rate of 8% on the borrowed money.

If you hold this margin position for one year, the interest on the borrowed amount is calculated as follows:

Interest = Borrowed amount × Interest rate

Interest = $10,000 × 8% = $800

So, you would owe $800 in interest on the borrowed money after one year.

If you decide to hold the position for over a year, the interest will continue accumulating. For example, if you hold the position for two years, the interest would be calculated as follows:

Interest = $10,000 × 8% × 2 years = $1,600

If you don’t repay the interest as it accrues, it will be added to your margin debt. Over time, the interest can compound, increasing your debt and the interest owed.

3. Risk of Bankruptcy

Traders have faced substantial losses or even bankruptcy by trading on margin. The tales of traders experiencing significant losses underscore the need to exercise caution and thoroughly understand the risks before engaging in margin trading.

4. Risk of a Margin Call

margin call is when your broker demands that you put additional money or securities into your margin account to bring it back up to its minimum required level (a.k.a maintenance margin). This call happens if the price of securities you bought on margin declines, causing the equity in your account to fall below the required maintenance margin.

For example, let’s say you buy $10,000 of TNA stock. You buy it with $5,000 of your own money and borrow the other $5,000 on margin. For your specific account, the maintenance margin requirement is 25%. Hence, the minimum required equity in the account should be $2,500. Unfortunately, the maintenance margin is breached if the stock value falls to $8,000. As a result, your broker issues you a margin call to deposit additional funds.

You can deposit cash or securities into your account to meet a margin call. Failure to meet a margin call could lead to your broker liquidating the securities in your account. The liquidation could result in substantial losses beyond your initial investment.

Traders must understand the risks associated with margin trading, including the possibility of margin calls, and ensure they have an appropriate risk management strategy.

Final Thoughts: Margin vs Cash Accounts

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. The margin account may make more sense for the trader seeking superior returns, who will closely monitor their positions.

Margin trading involves significant risks that traders should be aware of. Even though margin trading allows traders to control larger securities with borrowed money, the gains and losses are amplified. In some cases, losses can be unlimited. If the value of securities purchased on margin declines, it can erode the trader’s equity, potentially leading to substantial losses and even more than the initial investment.

Moreover, margin trading may only be suitable for some investors, as it requires a high level of risk tolerance and understanding of the associated risks. Traders must know how to manage risk before trading on margin. Adequate knowledge of potential risks, such as unlimited losses, margin interest debt, and significant fluctuations in equity, is required to make informed trading decisions and manage risks effectively. Check out our blog post on risk tolerance to learn more. 

Frequently Asked Questions

It depends. A cash account is likely the safest bet for newbies because you won't over-extend yourself. For experienced traders, margin can be a great tool to build their wealth. However, margin can be like playing with fire. You will get burned if you don't know what you're doing. 

One of the main things that sets a cash account apart from a margin account is the ability to borrow. In a margin account, the funds act as collateral for a loan your broker gives you. This allows you to have leverage and borrow more than what's in your account. 

Trading on margin carries many risks. For starters, your losses can exceed your initial investment. In fact, due to leverage, these losses can be unlimited.

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