Understanding Margin Account

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In order to start investing in stocks, investors must open a brokerage account. While opening an account, you need to decide which type of trading account you want to use – is it cash account or margin account? Cash account and margin account have their fair share of positive and negative sides. Determining which is the most suitable for your situations is an important decision that could have significant consequences on your financial life. Here are a few things you need to consider before picking which is appropriate for you.

WHAT IS A MARGIN ACCOUNT?

A margin account refers to a brokerage account in which the broker lets the customers borrow cash to buy additional securities. It allows them to purchase stocks on credit which is also known as buying on margin. Brokers normally give adequate credit for a customer to borrow up to half of the purchase price of a stock, which means the customer can buy twice as many shares of stock if they take full advantage of their margin limits. Because the customer is investing with a broker’s money rather than his own, the customer is using leverage to amplify both gains and losses.

Just like any other loan, customers need to pay interest on whatever margin they use. In a cash account, on one hand, customers can trade using the money available in their account. They cannot borrow money from a broker. In order to buy or sell stocks and other assets, they must deposit cash to settle the trade.

See also Tips for Picking an Online Broker

ADVANTAGES OF A MARGIN ACCOUNT

Opening a margin account can bring several advantages for you. As mentioned above, buying on margin gives traders a chance to potentially double their position sizes that can lead to larger returns. Additionally, margin accounts make short-selling possible, which gives margin traders more flexibility than cash traders. Margin traders can also have access to several advanced option trading strategies that may not be available to cash traders.

Margin accounts also make traders more flexible when it comes to settlement dates. Cash accounts traders need to wait two business days for cash to “settle” in their account after making a sale. Margin traders can use their available credit to proceed and make trades instantly after making a sale.

MARGIN VS CASH

DISADVANTAGES OF A MARGIN ACCOUNT

As margin accounts give traders more flexibility, they can also bring some unique disadvantages. Margin fees can range from as low as 1 percent to as high as 10 percent yearly depending on the broker and account size. Every cent paid in margin interest goes into investment returns.

Another disadvantage of a margin account is traders can be subject to what is called as ‘margin call’ if the value of their assets decreases below a certain threshold or account minimum. Most brokers require at least $2,000 in assets in a margin account at any given time. The equity in your account is like the collateral on the margin ‘loan’ your broker provides. If the equity value of the account declines on its lowest, brokers may require margin traders to sell assets or deposit more cash in the account. For investors looking to buy low and sell high, margin calls often arrive at the very worst time to be selling stocks, when prices are at their lowest.

WHICH STRATEGY IS RIGHT FOR YOU?

The answer to this question will ultimately depend on your risk tolerance and your knowledge of investing. If you are relatively inexperienced, investing with margin may not be the best idea. The same is true with an investor who wants to avoid higher-risk situations such as short-selling and stock options. However, if you are an experienced investor and you fully understand the risks involved and have an intent on taking advantage of more complex options strategies, short selling, and potentially even leveraging your buying power, then buying on margin could be a smart move.

The cash account, on one hand, is the safer and simpler choice for long-term buy-and-hold investors.

See also Questions to Ask Self Before Opening a Checking Account

Conclusion

Before opening either type of account, you, as a trader, should make sure that you carefully read any fine print of any agreement you sign and completely understand the potential risks involved.

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