What is a margin account vs cash account? We’ll go into this in detail by looking at each one separately. Then we’ll also look at why it matters when you are trading or investing. Knowing the difference is important when maintaining a trading account whether you are into trading stocks, futures, bonds, or forex.
Let’s look at what a cash account is first, as it’s the easiest to explain. When trading stocks a cash account, like your bank cash account, implies that all transactions are made against cash already available on the account.
All transactions traded on a cash account must have full backing in funds available in cash on the trading account. Once the stocks are bought, the standard for settlement is two days after the trade date. The settlement date is often referred to as T+2, meaning trade date plus two days.
Settlement refers to the delivery of securities and receipt of payment in cash. This transaction occurs automatically and is handled by your broker and the exchange. While the T+2 settlement date has been standard since 2017, the SEC is proposing reducing the time to settlement to T+1.
Something that was more usual in the past and tends not to happen due to the short time to settlement, is buying stocks and then funding the cash account. When stocks settled at T+3 it was possible to buy stocks for a greater value than the cash on your account.
You would then send funds to your broker cash account via a wire transfer and the account would be funded before settlement day. In general, your broker will not allow you to purchase stocks or bonds for a value that is greater than the funds on your cash account. With a cash account, you may not short-sell securities or trade against borrowed money.
If you are actively trading, you must make sure all trades settle correctly before making new securities purchases. To make sure you do not incur settlement violations bear in mind these three rules.
This happens when you don’t have enough cash in your account to make a stock purchase. However, you sell an amount of stock to cover the cost of the new purchase. After the sale is confirmed, you purchase stocks for the amount to be received.
Because settlement times may vary you may find that the stock purchase settles a few hours before your stock sale. This is considered a good faith violation, but it still has consequences. If you violate this rule 3 times in any 12-month period, your account will be restricted to cash-only trades for 90 days.
Freeriding occurs when you buy stocks and finance the purchase with proceeds from the sale of the same stock. Let’s say you buy $5,000 of stock ABC on Monday morning with a zero balance on your cash account. You intend to send a wire transfer to cover the trade.
However, on Tuesday the stock doubled in value due to a takeover rumor. You sell the $10,000 of stock ABC and determine you no longer need to send funds to your broker account. This is a freeriding violation as you have used funds to purchase stocks from the sale of the same stocks.
Your account will be restricted for 90 days if you incur this violation once in any 12-month period.
A cash liquidation violation happens when you cover the cost of stocks with the sale of fully purchased stocks after the purchase date. For example, on Monday you buy $5,000 of stock ABC, and on Tuesday you sell $7,500 of stock XYZ.
You have incurred a cash liquidation violation because brokerage rules require that you settle in cash the stocks you bought on T+2. While the funds received for the purchase would have arrived one day later.
If you incur 3 cash liquidation violations during any 12-month period, your account will be restricted for 90 days.
A margin account allows you to purchase stocks and bonds for a greater value than that of the funds on your account. This type of account is offered at most brokerage houses as they have an incentive to allow traders and investors to purchase more stocks and increase the volume of transactions.
The broker offering a margin account is in fact, lending the account holder the extra money used to purchase stocks. So, a margin account holder will pay interest to the broker for the borrowed money, usually monthly.
Margin accounts work slightly differently for futures as there is no exchange of principle. A futures contract may be worth hundreds of thousands, but you may only need a few thousand to buy or sell a contract. The money on the margin is used to settle the price difference only, on a daily basis.
For stocks, brokers are allowed to double the cash amount held as margin. This rule is regulated by the Federal Reserve and is known as Regulation T or Reg-T. So, if you have $10,000 on your margin account you can borrow up to another $10,000 from your broker.
The same rule also requires that the margin account always maintains at least 25 percent of the value in stocks held. These accounts also allow short selling and trading of other securities such as bonds and ETFs.
These are the requirements you must fulfill to set up and maintain a margin account.
The amount of leverage you can access is limited to a ratio of 2 to 1. In other words, you can purchase stocks for twice the initial amount of funds on your margin account.
After funding your margin account and making stock purchases that exceed the cash amount, their value could increase or decrease. That’s an obvious statement, but I say this because in the case their value decreases you may be obligated to add funds to your account.
The rules laid out by FINRA stipulate that you must at all times maintain a value of funds in your account equal to 25 percent of the position. Some brokers choose to apply a higher maintenance margin, often between 30 and 40 percent.
To clarify, let’s say you bought stocks worth $10,000 with $5,000 on margin. Their value declines by 30 percent to $7,000. Your initial margin requirement level is 50 percent which equals $3,500 which is the equity you have in these shares.
However, the broker applies a 40 percent maintenance margin rule. With this level of margin, you would need to have $4,200 of equity. As your equity is now at $3,500, half of the shares, you now have to add funds to your account to reach the 40 percent maintenance margin
Note that the lower the maintenance margin the earlier you will receive a margin call. This is the terminology used when a broker requires you to add more funds to your margin account to support a losing position.
You can also sell some of the shares and reduce your exposure until you satisfy the maintenance margin. Failure to do so obligates the broker to sell some of your shares until the rule is satisfied.
Margin account holders usually pay margin fees monthly, although some brokerages may allow for different schedules for certain types of clients. The fee is based on an interest rate and depends greatly on the financial resources the broker can count on.
Let’s say you open a margin account with $5,000, the broker supplies you the credit to borrow up to another $5,000. You can now purchase securities for a total value of up to $10,000. Usually, investors will use margin accounts for stocks and some ETFs.
The reason for this is that you pay interest on the borrowed money. So, traders and investors will look for assets that have a large enough potential to increase in value to cover the financing cost. With a bond, you may receive an interest payment that is lower than the interest you must pay for your margin account. And the prices of bonds tend not to change as quickly as do those of stocks.
Over time, the value of your stocks rises to $15,000, and you decide to exit that position and cash in on your gains. The result would be $10,000 – $5,000 which equals a profit of $5,000. When calculating your return on the trade you can measure the return on investment (ROI).
ROI would equal the profit divided by the capital multiplied by the leverage. In this case, the profit of $5,000 divided by the capital of $10,000 equals 0.50, multiplied by 2, which is the leverage, equals 100%. Basically, a margin account can allow you to double your profits and your losses, of course.
Trading on a margin account greatly amplifies your exposure to profits and losses. As with all financial markets, leverage is something to be used with caution. In particular, if you’re trading less known and more volatile stocks.
If you are setting out to day trade, you need to identify stocks that match a specific set of criteria. Not all stocks are suitable, and some stocks are simply better than others. You can also get the help of professional companies that specialize in stock picking. You can read their reviews here.
Gino D’Alessio is a Broker/Dealer with over twenty years experience in various OTC markets such as Bonds, FX and Derivatives. Currently a Financial Markets and Investments Writer & Analyst