Brokerage accounts allow you to buy securities with cash or even by borrowing against your assets. These two types of accounts are called a cash account and a margin account.
- Money bills are quite simple: you select your brokerage firm, deposit cash into your account, and then purchase securities directly.
- In one margin account you also deposit money and buy securities, but through the brokerage you can use these securities as collateral to buy other loaned securities. Margin accounts are also commonly used when executing options trades.
Both accounts allow investors to do different things, and understanding how they work can help you invest better.
How does a cash account work?
All transactions on a cash account must be completed with cash or existing positions. This means that purchasing securities is done either with cash already in the account (or to be deposited), or through the sale 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 lend their securities through their brokerage firm in a cash account to other investors or hedge funds, who may go short. This process is called securities lending, and many brokerage firms pay the lender a fee for participating.
How does a margin account work?
Similar to a cash account, investors deposit cash and purchase securities in a margin account. From there, the investor may borrow against the value of the money or securities in the account to purchase more securities or even withdraw cash using shares as collateral.
Under 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 one can open a margin account with before trading.
When initiating an equity position, investors can borrow up to 50 percent of the purchase price of the securities to be purchased on margin. This is called the initial margin and means that you cannot, for example, buy 70 percent of the purchase price on margin. Your brokerage firm may adjust this and require more than 50 percent of the purchase price to be deposited, depending on the risk of the security or other factors.
Once the securities are purchased, investors are required to maintain a “maintenance margin” 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). Under US Securities and Exchange Commission (SEC) rules, investors must have a minimum maintenance margin. of 25 percent equity at all times.
Your brokerage firm can further adjust the required collateral or loan limit and equity.
To use margin loans, investors also have to pay interest on the margin loan. The rate varies by broker, but rates are usually graduated and decrease as the amount of the loan increases. The interest charges on the loan are rolled onto the balance of the loan.
Benefits of a Margin Account
A margin account can provide benefits to those who use it, and a margin account is also imperative if you want to go short.
Margin accounts can increase your returns
For the cautious investor, margin accounts can offer enormous upside potential. Those who trade on margin accounts purchase larger amounts of securities than they would normally be able to do with just their own money, allowing for greater profits. If you pick the right stock, the upside potential is enormous. You keep the profits in a margin account position, minus any fees charged by the brokerage.
Your equity is collateral
One of the biggest benefits of trading on a margin account is the ability to use your own securities as collateral. You already own the equity and do not need to sign any new paperwork or loan documents as you would with other types of loans.
Margin accounts are necessary for short sellers
Margin accounts can also benefit short sellers, and brokers require short sellers to have these types of accounts. Shorting a stock means you are betting on 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 buy back the shares, ideally at a lower price. If the stock price falls, short sellers will benefit.
If the price rises, short sellers must have enough capacity in their margin accounts to cover and redeem the position.
Margin accounts are subject to margin calls
If you borrow too much money from your margin account, you could get into trouble – which is called a margin call. Margin calls take place 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 required equity in the account.
Margins can work well as long as stocks are rising, but can become disastrous if stocks fall.
Let’s assume an investor owns $20,000 worth of stock, purchased with $10,000 in cash and $10,000 on margin. The account has 50 percent equity, 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 rises to $25,000. The investor now has $15,000 equity in the account ($10,000 original deposit + $5,000 capital appreciation), or 60 percent equity. But the margin balance still remains $10,000 (plus any accrued interest).
But the margin detracts significantly from the value of the account when stocks fall. In our example, let’s say the value of the shares in the margin account now suddenly drops to $12,000. The investor still owes the original $10,000, and the remaining equity in the account is only $2,000.
This €2,000 now represents only 16.6 percent of the equity of the total account value of €12,000, triggering a margin call. When equity falls below the maintenance margin, typically 25 percent, the broker makes a margin call calling for more equity in the account. The investor must deposit cash or sell certain positions to restore the minimum equity.
Risks of a margin account
Margin accounts carry inherent risks that cannot be overlooked. Borrowing money for anything is a risk, but especially for securities, where the value of your collateral fluctuates.
- Price fluctuations
- Stocks can fluctuate in price from day to day, and trading on margin exacerbates these movements, making your portfolio even more volatile.
- Big losses
- It is possible to lose more money than you have in the margin account and end up owing more money than you originally deposited.
- Forced sales
- Brokerage firms can force the sale of the securities in a margin account if its value falls significantly below the required equity.
- Brokers do not need to contact you
- Although most companies will attempt to contact you as a courtesy before liquidating securities, they are under no obligation to contact you to sell you out of your position.
Should you open a margin account?
Borrowing from a margin account is risky and should generally only be considered by experienced investors. Due to the inherent risks, a lot of knowledge is required 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 must have significant knowledge of what they are investing in and the money they could potentially lose.
Potential margin investors should consider whether or not they need a margin account. Margin accounts require active involvement, sometimes every day, mainly because of the possibility of a margin call.
It is important to understand what type of investor you are. If passive investing with slow and steady returns is your goal, then margin accounts may not be necessary for you.
The level of personal market knowledge is also critical to take into account when considering margin lending. Especially when shorting stocks, an investor must know very well both the stocks he is shorting and the market in order to place such a bet.
In short
For the right investor, margin accounts can provide a viable opportunity for big profits, but they come with significant risks. Losing money quickly and the possible forced sale of your securities are some of the risks to consider in this type of trading.