When you decide to start trading, one of the first steps is to open your broker account. Once you choose your broker, you are given two choices: cash vs margin accounts.
The account type you open can affect the way you trade, especially if you are a day trader subject to the pattern day trader rule. This guide will break down the differences between cash and margin accounts so you can be informed before you open up your brokerage account.
Cash accounts are pretty simple. Unlike margin accounts, you can only trade with the money you have on hand—you can’t borrow money from your broker. The pro of using this type of account is that you can prevent large trading losses, but on the other side, you don’t have as much purchasing power.
Additionally, if you are limited by the pattern day trader rule, cash accounts are not subjected to this rule. If you have under $25,000 in your account, then you can day trade with a cash account, since you are using your own money and not margin. You also will never get a margin call, since you can’t use margin and owe margin debt.
However, you must wait until your cash has settled before placing your trades, and you have to wait for trades to settle before you withdraw any cash you made with sold shares. For example, if you make a day trade with a profit of $250, you have to wait a few days after the trade was made to use that cash for a new trade.
Additionally, cash accounts are not eligible to short stocks, and the stocks you hold can’t be lent out to short sellers.
Examples of a Trade in a Cash Account:
- You buy a stock for the price of $10. It rises to $15. You’ve earned a 50% return on investment.
- You buy a stock for the price of $10. It decreases to $5. You’ve lost 50% of your investment.
Margin accounts allow you to borrow money from your broker, which helps increase your buying power. However, since your broker is lending you money, with your account as collateral, there are additional requirements to opening up a margin account. You also will likely have to pay a fee for using margin.
Up to 50% of your purchase can be on margin, depending on your broker and account size. However, you don’t have to use up to 50%. You could do 30%, 25%, 10% or some other amount of borrowed money.
If you have $10,000 in your account and want to use the full 50% margin, you have a buying power of $20,000.
Additionally, your broker may lend out your shares to short sellers.
Using margin adds an additional level of risk to your trades, but for day traders, it helps increase your buying power.
Examples of a Trade in a Margin Account:
- You buy a stock for the price of $10. You pay $5, and borrow the other $5 on margin from your broker. The stock rises to $15, and you’ve made a 100% return on investment on the $5 you invested, excluding any brokerage fees or interest.
- You buy a stock for the price of $10. You pay $5, and borrow the other $5 on margin from your broker. The stock decreases to $5. You’ve lost 100% of your investment, excluding brokerage fees and interest.
While the ability to gain is greater with a margin account, you also risk greater loss. However, for day traders who meet the PDT rule, margin can be extremely helpful if you know what you’re doing.
Additionally, penny stocks, IPOs, and over-the-counter Bulletin Board stocks are not eligible for margin trading, due to higher risks.
Margin accounts all have requirements for maintenance, which is the minimum amount of equity you must have in your account. Equity is the value of your holdings, minus the money owed to the broker.
When your equity drops below the minimum requirement, your brokerage will issue you a margin call, requiring you to add more cash/securities by a certain date. Your broker may also sell your holdings without notice.
Margin accounts typically allow you to short stocks. Short selling is the strategy where you borrow shares, sell them, then hopefully buy them back to return at a lower price. Note: Short selling typically has fees on top of interest.
Read More: What is Short Selling Stocks?
Opening a Margin Account
As mentioned previously, margin accounts typically have more requirements for opening an account.
First, the minimum amount you’ll need to deposit is $2,000, as it is federally required. Some brokers may require more. When opening your account, you’ll also need to allow your broker to do a credit check, and give information about your income and assets.
The choice of a cash or margin account is important to make. It will affect your buying power, how often you can day trade, and amplify your gains and losses. Take time to think about the pros and cons, and which one would work best for your trading strategy and account funds.