How Does A Cash Account Work
A cash account allows you to purchase securities with the cash in your account. If youve deposited $5,000, for example, you can purchase up to $5,000 in securities. If youd like to buy more, you have to deposit additional funds in your account or sell some of your investments.
Notably, with a cash account, your potential losses are always capped to the amount you invest. If you invest $5,000 in a stock, the most money you can lose is $5,000. For this reason, cash accounts are the better choice for new investors.
What Are The Risks That Come With Margin Accounts
There are a variety of risks that come with trading or investing with margin. The two main risks are:
- The investor can lose more money. Instead of losing 5% on $100,000, if you use a margin account you may lose 5% on $200,000.
- If a margin call is pressed forward, a brokerage can sell securities in your account. There is nothing that states these securities must be sold at the most ideal price.
What Are Maintenance Requirements And Margin Calls
With a traditional loan , the value of the asset purchased with borrowed money has no bearing on the terms of the loan once the paperwork is signed.
If one year home sales in the neighborhood are sluggish and the algorithm on your favorite real estate search engine says that your house is worth less than what you paid for it, thats merely a paper loss. The bank isnt going to raise your interest rate or ask you to reapply for a loan. Nor will the lender force you to sell your house, or if you wont do that, possess your car and sell it for cash.
But if mortgages worked like margin loans, thats exactly the kind of scenario that a homeowner would face.
If the value of those securities dips and the collateral falls below the maintenance level , the broker will issue a .
At that point an investor has from a few hours to a few days to bring the account value up to the minimum maintenance level. She can do that by depositing more cash or selling equities to increase the amount of cash in the account.
Miss the margin call deadline, and the broker will decide which stocks or other investments to liquidate to bring the account in line.
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The Benefits Of A Margin Account
While buying on margin can be risky, opening a margin account has certain benefits. There are generally no additional fees to maintain a margin account, and it can be really useful when it comes to short-term cash flow needs.
If you need cash from your brokerage account in a hurry, you may not have time to wait for your broker to sell stocks and deposit the proceedssettlement can take up to a few days. If you have margin available, your brokerage can give you instant access to cash, which you can back when convenient, either with a cash deposit or by selling securities.
The amount youd pay in margin loan interest is minimal, so long as you pay it back in a relatively short period of time. The margin can almost be like an overdraft line of credit, Bishop says.
Margin accounts can be helpful in both up and down markets. In down markets, you dont have to sell stocks at a loss if youd rather take a margin loan and wait for the market to recover . When the market is up, margin may help you delay realizing a short-term capital gain, which can trigger high taxes. Taking a margin loan and wait until youre able to benefit from the lower long-term capital gains tax rates.
Everything You Need To Know About Margin Accounts
For example, lets say you have approximately $5,000 in your margin account, but want to purchase 100 shares of ABC Corporation, which is currently trading at $100 per share. You require a total of $10,000 to make this purchase , so you borrow the additional $5,000 from your broker to do so. You now own the 100 shares you wanted, but the 50 you purchased with the loan from your broker are held as collateral. Additionally, you will begin to accumulate interest on the $5,000 you borrowed, until the loan is repaid.
Using a margin account in this manner allows you to increase the amount of money you invest, which enhances your potential profit. At the same time, purchasing securities with borrowed assets magnifies any potential losses if the securities decrease in value, not only could you lose money on your investment, but you would still owe the broker for the original loan and any interest.
With so many variables and diverse outcomes, understanding the potential risks and rewards of a margin account are key to determining whether this solution is right for you.
WHY USE A MARGIN ACCOUNT?
RISKS OF BORROWING TO INVEST
Just as the rewards you can reap when investing with borrowed money are higher, losses can be felt more intensely as well. With increased buying power comes increased costs while you have more capital to invest, you now have to pay back your loan, with interest, even if the value of your investment decreases.
SO, IS A MARGIN ACCOUNT RIGHT FOR YOU?
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Whats Next: Consulting A Financial Advisor
Are you unsure about the next move you should make? Do you feel like you are ready to invest in Margin accounts. Or do you feel like you would prefer to be assisted by an experienced financial advisor? Margin accounts are risky and every investment you make should be carefully considered so that you understand all of the potential outcomes.
A financial advisor can help you understand how to manage margin accounts, interest rates, and increase the value of your investments. You should consider utilizing a financial advisor to help keep you organized and prepared to make wise investments. Financial planning requires a lot of time and dedication. It is important to keep a regular account of all your expenses associated with owning a margin account.
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What Is The Benefit Of A Margin Account
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You Need A Margin Account For Short Selling
Short selling is a speculative trading strategy where you aim to profit from a decline in a stocks price. When you open a brokerage account, you need to choose a margin account to pursue short selling. Like buying on margin, short selling is a sophisticated strategy thats not for novice investors, and the potential losses from a bad trade are much, much higher.
Selling a stock short works like this: You borrow a particular stock from another holder via your brokerage account, you immediately sell the stock and pocket the profit from the sale, and then wait for the value of the stock to fall. If and when the stocks market value declines, you buy it back and return it to the original owner.
Think of short selling as a kind of mirror of conventional stock investing. Instead of buying a stock in the hopes that its value increases, youre betting the value of a stock will decrease and youll be able to replace the shares you borrow for a much lower price than you sold them for.
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The Ability To Profit From Share Price Declines
Short selling is a sophisticated strategy whereby an investor seeks to profit from a declining share price. In order to sell a security short, you must first borrow shares of stock from a brokerage firm, which requires that you have an approved margin account.
After you borrow shares, you sell them and then buy them back at a later date, presumably at a lower price. The difference between the proceeds of the original sale minus the amount required to buy back the shares would be your profit.
Assume that, after doing your research, you concluded that ABC Company was unlikely to meet its revenue goals due to a successful new product launch from ABCs foremost competitor. You then use your margin account to borrow 100 shares of ABC stock and sell it short at $50 a share for a total of $5,000 .
Six months later, ABCs stock price has declined 20% to $40. You buy 100 shares at $40, return the 100 shares of stock to your brokerage firm, and pocket the difference of $1,000 . This is another example of how trading on margin can provide opportunities to leverage your assets for financial gain.
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Understand Margin Calls You Can Lose Your Money Fast And With No Notice
If your account falls below the firm’s maintenance requirement, your firm generally will make a margin call to ask you to deposit more cash or securities into your account. When a margin call occurs you generally cannot purchase any additional securities in your account until you satisfy the margin call requirements. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm’s maintenance requirement.
However, your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm’s maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.
How To Open A Margin Account To Spread Bet Or Trade Cfds
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The Main Difference Between A Margin Account Vs Cash Account
The simplest way to explain the difference between a margin account vs. cash account is this:
A margin account lets you borrow from your broker. A cash account doesn’t.
With a margin account, you can make investments on margin. That means you don’t need to pay the full cost of the investment upfront, as your broker covers part of that for you.
If you have a cash account, you can only make investments that you pay for upfront using the money you have in your account.
It may seem like a cash account is the way to go if you never intend on investing with margin loans. However, there are other situations where a margin account and margin trading can come in handy. By knowing more about how each type of account works, you can make a more informed decision on choosing a margin account vs. cash account.
How To Manage Margin Account Risk
If you decide to invest with a margin account, you can decrease your risk a few ways:
- Keep a cash cushion. A cash buffer in your margin account can help decrease the chances of facing a margin call. The extra cash buffer gives you extra scope to maintain the required value of your account.
- Dont pursue highly speculative investments. Margin investing only makes sense if your returns are greater than what youre paying in interest on the margin loan. Its not wise to buy speculative investments in a margin account, as highly speculative bets can rapidly lose value, forcing margin calls.
- Keep an eye on your interest costs. Even though most margin accounts wont have a set schedule for loan repayment, you must be aware of the interest costs youre accruing. Regularly paying down interest charges keeps your balance from creeping higher and eating into your cash cushion.
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How Does Margin Work
Brokerage customers who sign a margin agreement can generally borrow up to 50% of the purchase price of new marginable investments . As we’ll see below, that means an investor who uses margin could theoretically buy double the amount of stocks than if they’d used cash only. Few investors are that extremethe more you borrow, the more risk you take onbut 50% makes for simple examples.
For example, if you have $5,000 cash in a margin-approved brokerage account, you could buy up to $10,000 worth of marginable stock: You would use your cash to buy the first $5,000 worth, and your brokerage firm would lend you another $5,000 for the rest, with the marginable stock you purchased serving as collateral.
The total amount you can deploy using margin is known as your buying power, which in this case amounts to $10,000. .
New securities aren’t the only source of collateral. You can also often borrow against the marginable stocks, bonds, and mutual funds already in your account. For example, if you have $5,000 worth of marginable stocks in your account and you haven’t yet borrowed against them, you can purchase another $5,000. The stock you already own provides the collateral for the first $2,500, and the newly purchased marginable stock provides the collateral for the second $2,500. You now have $10,000 worth of stock in your account at a 50% loan value, with no additional cash outlay.
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The Dangers Of A Margin Account
The potential for investments that have been bought on credit to lose value is the biggest risk of buying on margin. While a margin account can amplify your gains, it can also magnify your losses. Having to liquidate stocks during a margin call, because market losses have reduced the value of your investments, makes it very challenging to invest for the long term in a margin account.
With a cash account, the investor has the luxury of waiting for a stock to recover in price before selling at a loss, Lach says. Thats not the case with margin accounts, meaning you may end up losing money on a stock that would have eventually rebounded.
In addition to giving you the flexibility to invest for long-term growth, buying with cash creates a floor for your losses. Whether in a cash account or margin account, investments purchased with cash will only ever cost you the amount you invest.
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A Buying Power Example
Let’s say you deposit $10,000 in your margin account. Because you put up 50% of the purchase price , this means you have $20,000 worth of buying power. Then, if you buy $5,000 worth of this stock, you still have $15,000 in buying power remaining. You have enough cash to cover this transaction and thus haven’t tapped into your margin. You start borrowing the money only when you buy securities worth over $10,000.
This brings us to an important point: the buying power of a margin account changes daily depending on the price movement of the marginable securities in the account. Later in the tutorial, we’ll go over what happens when securities rise or fall.
