Cash Account vs. Margin Account: An Overview
Investors who want to buy securities can do so using a brokerage account. Cash accounts and margin accounts are main types of brokerage accounts, with the main difference between these two being their respective monetary requirements.
Key Takeaways
- Cash and margin accounts are the two main types of brokerage accounts.
- A cash account requires that all transactions be made with available cash.
- A margin account allows investors to borrow money against the value of securities in their account.
Cash Account
In a cash account,all transactions must be made with available cash. When buying securities, the investor must deposit cash to settle the trade or sell an existing position on the same trading day, so that cash proceeds are available to settle the buyorder. These accounts are fairly straightforward.
If you give your brokerage firm permission, shares held in a cash account can also be lent out to other interested parties, including short sellers and hedge funds. This process, called share lending, or securities lending, can be a source of additional gain for an investor.
If you have a cash account with securities that are in demand for short sellers and hedge funds, you can let your broker know that you are willing to lend out your shares. If there is a demand for these shares, your broker will provide you with a quote on what they would be willing to pay you to lend these shares.
If you accept, your broker will lend your shares out to a shortselleror hedge fund for a higher rate. For example, your broker may give you 8% interest on the loaned shares, while lending out at 13%. Depending on the size of your position, it can be a generous source of return. This method also allows you to keep your existing long positionin the security and benefit from its upward movement.
There can be a lot of demand byshort sellersand hedgefunds to borrow securities, especially on those that are typically hard to borrow. When borrowing capital or securities, the borrower must pay fees and interest on the amount borrowed.
Depending on market rates and the demand for the securities, the amount of interest charged for borrowing securities will vary. The most attractive securities to lend are those that are the hardest to borrow forshort selling. That could apply to companies with a small market capitalization orthinly tradedstocks. Shares heavily shorted may also be attractive for lending.
Brokers don’t automatically provide this type of service. Even those who do offer it may also require a minimum number of shares or dollar amount.
Margin Account
A margin account allows an investor to borrow against the value of the assets in the account to buy new positions or sell short. Investors can use margin to leverage their positions and profit from both bullish and bearish moves in the market. Margin is also used to make cash withdrawals against the value of the account as a short-term loan.
As an investor, if you are seeking to leverage your positions, a margin account can be very useful and cost-effective. When a margin balance (debit) is created, the outstanding balance is subject to a daily interest rate charged by the firm. These rates, which can be quite high, are based on the current prime rate, plus an additional amount that the lending firm charges.
For example, an investor with a margin account may take a short position in XYZ stock if they believe the price is likely to fall. If the price does indeed fall, they can cover their short position at that time by taking a long position in XYZ stock. Therefore, they earn a profit on the difference between the amount received at the initial short-sale transaction and the amount they paid to buy the shares at the lower price, less their margin interest charges during that time.
In a cash account, the same investor in this scenario must find other strategies to hedge or produce income on their account, since they must use cash deposits for long positions only. For example, they may enter a stop order to sell XYZ stock if it drops below a certain price, which limits their downside risk.
Margin accounts must maintain a certain margin ratio at all times. If the account value falls below this limit, the client receives a margin call. A margin call is a demand for a deposit of more cash or a sale of securities in the account to bring the account value back within the limits. The client can pump in new cash to their account or sell some of their holdings to raise cash.
Margin privileges are not offered on individual retirement accounts (IRAs), because they are subject to annual contribution limits, which impacts the ability to meet margin calls.
Other Uses of Margin Accounts
In a margin account, the investor may lend out securities to another party. In addition, it can be used as collateral by the brokerage firm, atany timewithout notice or compensation to the investor if they hold a debt balance (or a negative balance) on the account. If the account is in a credit state, where you haven’t used the margin funds, the shares can’t be lent out.
The borrowers of stocks held in margin accounts are generally activetraders, such ashedge funds. They are typically either trying toshort a stockor needing to cover a stock loan that has been called in. Investment firms that need an underlying instrument for aderivativescontract might borrow margined stocks from a brokerage firm, which may also pledge the securities as loan collateral.
Additionally, if an investor’s margined shares pay adividendbut are lent out, then the investor does not receive real dividends because they aren’t the official holder. Instead, they receive “payments in lieu of dividends,” which may carry different tax implications.When the shares are lent out, the investor may also lose their voting rights.
What is a margin call?
A margin calloccurs when the percentage of an investor’s equity in amargin accountfalls below the broker’s required amount. An investor’s margin account contains securities bought with a combination of the investor’s own money and money borrowed from the investor’s broker.
The term refers specifically to a broker’s demand that an investor deposit additional money or securities into the account, so that the value of the investor’s equity (and the account value) rises to a minimum value indicated by themaintenance requirement.
A margin call is usually an indicator that securities held in the margin account have decreased in value. When that occurs, the investor must choose to either deposit additional funds or marginable securities in the account or sell some of the assets held in their account.
What is short selling?
Short selling is an investment or trading strategy that speculates on the decline in astockor othersecurity’s price. This is an advanced strategy that should only be undertaken by experienced traders and investors.
Traders may use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one.
Short selling carries the possibility of substantialrisk. This risk is theoretically unlimited, since the price of any asset can climb to infinity.
What is a long position?
A long positiondescribes what an investor has purchased when they buy a security or derivative with the expectation that it will rise in value. Investors can establish long positions in securities such as stocks, mutual funds, currencies, or even in derivatives such as options and futures. Holding a long position is usually considered bullish.
The Bottom Line
A cash account and a margin account are two ways for investors to purchase securities. The difference is in the monetary requirements of each.
In a cash account,all transactions must be made with available cash. When buying securities, the investor must deposit cash to settle the trade, or sell an existing position on the same trading day, so that cash proceeds are available to settle the buyorder. A margin account allows an investor to borrow against the value of the assets in the account to buy new positions or sell short.
