Cash Accounts vs Margin Accounts

Ok, today is the day, you have finally decided to open an account with a brokerage firm! Assuming you have done some research on the fees different brokerage firms have, and based on your location, you have made a choice. Now the next question you have to answer is what type of account you want to open. Is it a margin or a cash account? To answer this question let us analyze the two.

A cash account allows you to buy securities (eg: stocks, bonds, index funds, etc.) using only the capital that you have. Therefore, with a cash account, the most you could potentially lose is capped to the amount you invest. Additionally, you can give the brokerage firm permission to do share lending / securities lending. This means that the shares held in your cash account can be lent to other interested parties, generating an additional return for you, the investor.

A margin account allows you to borrow money from your broker to buy more securities than you could purchase with the capital that you have. This allows you to potentially amplify your returns, but you could also potentially lose more money than you have in your account. Therefore, a margin account enables you to use leverage to increase the potential returns of your investment. The securities purchased are the collateral for the loan. If the securities purchased decline in value, the same happens to the value of the collateral supporting your loan. Thus, as a result, the broker could sell assets in any of the accounts that you have with them, to maintain the required equity in the account for your loan.

Let us take two examples, a positive and a negative one.

Positive example

Let us assume you have $1000 in your margin account, but you want to buy securities that cost $2000. Therefore, you borrow $1000 from your broker to purchase securities worth $2000. The value of the securities serves as collateral for the loan the broker has given you. If the value of the securities increases to $3000 and you sell them, you keep what remains after paying back the broker, plus the interest. Your proceeds equal $2000 (minus interest charges) resulting in a 100% return on your initial investment of $1000. Had you initially paid for the entire $2000 yourself and sold at $3000 your gain would only have corresponded to 50% of the initial investment.

Negative example

You have to keep in mind that leverage amplifies losses in the same way as it amplifies gains. Suppose the value of the securities decreases to $1500 and you sell them to prevent further losses. After paying your broker the $1000 you borrowed, your proceeds come to $500. You have lost 50% of your original investment. Without margin, however, a loss in value from $2000 to $1500 would only have counted for a 25% loss.

Whether you open a cash or a margin account is a personal choice that you should make based on how much risk you are comfortable taking, your experience with leverage, and your investment strategy. However, never forget that when using a margin account with leverage, you can not only potentially amplify returns but also potentially amplify losses.