To trade in the stock market, a person needs a brokerage account. There are two kinds of brokerage accounts: cash accounts and margin accounts.
What is a cash account?
A cash account allows a trader to make purchases using only money from their pocket. A trader can’t borrow money from the broker-dealer to purchase with a cash account. The goal is to invest as much as possible directly into the market without borrowing any capital.
Cash accounts are generally recommended for novice traders that will be trading for short periods because it reduces risk if they’re inexperienced and still learning how to trade stocks. Cash accounts may also be used by experienced traders who want more control over their trading capital – perhaps by placing stop orders and otherwise limiting losses on individual trades.
What is a margin account?
A margin account requires a minimum deposit of cash or securities but allows a trader to buy stocks by borrowing money from the broker-dealer. A margin loan usually has a lower interest rate than a cash account and is more suitable for making large stock purchases, including short selling (when an investor borrows stock in the hope of repurchasing it at a lower price).
Margin trading can be hazardous because traders are generally allowed to borrow up to 50 percent of the purchase value of the shares they buy. Thus, if you pay $10 per share for 100 shares ($1,000), you only need $500 in your account. Borrowing lets investors buy more than they can afford—but if their picks rise in value, they can make larger profits by selling at a higher price. The danger is that the stock could fall instead of rising, leaving traders with heavy losses and little money left to cover their losses.
Benefits of margin trading?
Purchasing power – $100 cash invested in shares purchased using $50 borrowed from your broker will purchase two hundred more shares than if purchased with just cash ($200 total). Additionally, the total amount you pay for the additional one hundred shares purchased would usually be less than had you purchased it with cash because “buying on margin” spreads an interest charge over the total value of the purchase.
The ability to short sell – sometimes called “selling short” is a method for selling shares you don’t own and repurchasing them later at a lower price. It can be an effective tool if you know, or think, that the price of a share will fall dramatically before you must replace your borrowed stock (most brokers require that stocks be returned within three days).
Speculating (margin trading) differs from investing because investors buy and hold good companies for long periods, hoping they’ll grow in value. Speculators tend to trade more frequently, so they look at potential profits using different strategies, such as short-term trading trends or trading breakouts from specific price patterns. The following will help you decide whether a cash account or a margin account is best for you:
- You have plenty of money to invest. Your primary goal is to limit risk by making as significant an investment as possible in the market without borrowing any capital from brokers.
- You’re willing to take on more risk, but not too much – for example, you want a margin account because it generally has a lower interest rate than a cash account and allows short selling.
- You want to speculate – that is, trade frequently based on short-term price movements – rather than invest in promising companies over more extended periods.
The downside of margin trading?
Total potential losses – if prices fall way below their purchase value, you could call on you to pay more money or securities than you have in your account. For example, suppose a trader’s portfolio slips below a specific value set by the broker-dealer (usually 25 percent of securities plus cash).
In that case, the broker will issue a “margin call,” requiring the investor to deposit more money or sell off some of their positions immediately. In other words, if an investor buys $100 worth of stock using a 50 percent margin and the price falls 10%, they are required to bring another $10 into their account before selling any shares.
