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There are several ways for an investor to trade in the financial markets, and most of those ways need a broker to give you access to trading platforms and tools and act as an intermediate, connecting you with different financial markets.
To start trading, most brokers offer you a cash investing account or a margin investing account, and each account has requirements, limitations, and features depending on your expectations, experience, and capital. So, how do these accounts differ, and which one suits you better? Let’s answer these questions.
Investing with a cash account allows trading only with the accessible balance or using available assets like stocks.
Investing with a margin account allows trading through borrowing funds from the broker to explore more trading options.
Margin accounts are riskier than cash accounts because they allow leverage, exposing the trader to more possible gains and risks if the trade loses.
The margin requirement is the minimum amount the trader must have to fund an investment before the broker issues a margin call when the trader’s equity falls below the minimum requirement.
This type of account is more common and straightforward. It implies trading with the money in your trading account deposited by a bank transfer, online transfer, or other payments at the broker’s platform.
Once you add funds to your account, the broker uses it in two ways. Your broker will contribute your cash in liquidity pools and market-making funds, which are safer financial investments in exchange for a small percentage.
The other option is to open a checking account associated with the trading platform, where you can access your funds anytime and use your balance to invest in the given financial markets and instruments.
Why Use a Cash Account?
Risk-averse traders prefer cash accounts, allowing them to trade only with the money they have or only sell the assets they own. A cash account trading does not allow borrowing funds from brokers and does not allow leverage.
Also, traders who hold on to their assets or keep their trading positions open for an extended period prefer this type of account because it does not involve any loan payment or loan due date.
How Does a Cash Account Work?
Initially, these were called “cash accounts” because they required physical cash payments to the broker when the trader wanted to invest in a particular security. Now, payments can be made in cash, by transfers, and by bank cheques.
When a trader requests a buy position, for example, the platform will check the asset’s price, and if the trader has an available balance, the money will be automatically deducted from the account.
Similarly, If a trader puts in a sell request, say for 10 shares, the platform will check if the account has 10 shares at least to put in the market as a sell position.
This way, traders cannot buy assets they cannot afford and cannot sell assets they do not own.
A cash brokerage account has a settlement cycle for every time a trader conducts a transaction. The settlement period in the stock market is T+2 (2 days from the transaction date), so if a trader performs a trade (buy or sell) on Wednesday, their transaction will not be settled before Friday.
Traders cannot use the settlement money until it is over. For example, if a trader purchased $100 worth of shares on Wednesday, they will receive the shares and become the new owner on Friday, and until then, they cannot use the money until settlement is done.
In opposition to the cash account, the margin account is a brokerage account that allows traders to borrow money from brokers to explore more trading opportunities. Using a margin account, a trader can use leverage, short on stocks, borrow and lend with the broker to fund trades.
Margin accounts are riskier than cash accounts because they allow investors to purchase securities with borrowed money, and in its nature, trading can go sideways. However, if a trade goes successfully, a trader may boost their gains with borrowed money and pay the broker back.
However, a trader must comply with the margin account requirements of the brokerage firm and the financial industry regulatory authority.
Why Use a Margin Account?
Traders invest in margin accounts to trade with leverage, which extends their buying power to buy securities with more cash using the broker’s money.
The leverage is usually expressed in ratios like 1:10, which means that every $1 from the trader will be multiplied by 10 from the broker. Thus, if a trader has $10, a 1:10 leverage ratio means they can trade with $100.
Traders open a margin account to borrow money from the brokerage firm and fund trades that they cannot usually afford with their money. However, the margin account loan comes with a margin interest rate the trader must repay.
Also, stock traders who engage in short selling can open a margin account to sell stocks they do not own and offset it with a long position.
For example, if a trader speculates the stock ABC’s price to decrease but does not own stocks for this opportunity, they can borrow and sell stocks from the broker. After the stock price falls, they can close it with a long position to reap the gains, return the stocks to the broker and collect their earnings.
The FCA of the UK sets the maximum leverage limits to 1:30. However, qualified professional traders are allowed to leverage up to 1:500.
How Does a Margin Account Work?
The margin account requirements represent the amount of money a trader must have in their account to use the leverage.
The requirement is expressed in percentage; for example, if the maintenance margin is 25%, the trader shall fund 25% of the security’s purchase price while the broker leverages the remaining 75%.
After opening a leveraged trade and if the position starts losing, the trader’s equity may fall below the minimum maintenance margin. In this case, the broker will issue a margin call asking for additional funds.
A margin call happens in margin trading when the trader’s equity falls below the initial margin. When margin calls occur, the broker will ask the trader to deposit cash in the account or liquidate some of their assets to increase the account equity.
Unlike cash accounts, margin accounts do not have a settlement period, and the trader receives their money or assets directly after buying or selling securities.
Face To Face: Cash Account And Margin Account
After learning how each account works and the main difference between them, let’s compare margin account vs. cash account and find the better account type for you.
Cash and margin accounts allow you to explore various trading opportunities. However, some trading options are only available with a margin investment account because they require borrowing or leverage.
A cash account trading options include most trading markets like stocks, bonds, index and mutual funds, ETFs, and cryptocurrencies.
However, a trader must have enough cash balance that matches the purchase price to buy any security, and they must have assets before selling them in the financial market, whereas they cannot sell assets they do not own.
On the other hand, margin accounts allow traders to explore more trading opportunities like short-selling stocks (selling stocks they do not own), engaging in Forex trading, and futures contracts. However, this type of account comes with a margin loan interest and must be carefully treated because it is a risky strategy.
Cash accounts do not allow leverage, and a trader can only purchase securities with the deposited cash in the cash account.
Margin accounts allow leverage and borrowing money from the brokerage firm. However, they entail more risks the trader must know, such as the margin call, maintenance margin requirements, and the margin loan.
Leverage in margin accounts is expressed in ratios, enabling the trader to explore great opportunities they cannot afford. For example, suppose they speculate that a company’s stock price will significantly increase after an exclusive introduction. In that case, a trader wants to buy 50 stocks worth $10,000, but a trader has $100 in their account.
In this case, they can use 1:100 leverage, multiplying their $100 by 100 and enabling them to trade with $10,000 worth of investment. This move can signify their gains if the market moves as expected.
However, this is a risky strategy because if the market moves against their preference and loses the position, they become in massive debt to the broker that they must cover before the broker liquidates their account or incurs additional charges.
Cash accounts are straightforward and do not have additional requirements other than a minimum cash deposit according to the broker’s requirements. The minimum deposit varies between brokerage firms; some set the minimum to $10 while others to $1,000.
On the other hand, the margin account entails minimum cash deposits to open a new margin account and additional funds if a margin call happens or if the maintenance margin falls below the minimum.
Margin accounts include a margin maintenance minimum, for example, 25%, meaning the trader’s equity must cover 25% of the investment while the brokerage account funds the remaining amount.
If the trader’s equity falls below 25%, the broker will issue a call to the trader requiring them to add more cash in the account to support the margin minimum or sell some of their stocks to the market to increase the money in their margin account.
Using a cash account, a trader can start position trading, a classic trading strategy to open a position when the price is expected to increase.
This strategy suits stock or bond trading if a trader wants to hold stocks long-term and receive dividends or annual percentage yield from owning a bond certificate.
On the other hand, a trader with a margin account can use complex investment strategies like scalping or swing trading. Scalping entails the quick buying or selling of assets, which may require borrowing to short some stocks in a short period.
Margin accounts can also be used for intraday trading, allowing a trader to enter and exit a trading position on the same day using leverage to exaggerate their potential gains.
Which Is Better: Margin Or Cash Account?
Choosing a suitable trading account depends on your preference, trading style, and strategy. If you are a risk-taker, you can use a margin account and leverage to enter a high-risk/high-gain position and utilise the chance to double your gains.
Active traders usually use a margin account because they carefully watch their trades and calculate their risks before taking them.
You can also use a margin account if you are a stock trader and want to short-sell stocks, while currency traders can use margin accounts to scalp small gains in a liquid and volatile market.
On the other hand, if you are a risk-averse trader, it is better to use a cash account where you trade using the cash deposits you have in the account and deposit cash again whenever you are short in funds.
This account is better for risk management because you cannot enter leveraged trading positions or borrow funds from the broker. Cash brokerage accounts are suitable for long-term trading if you want to hold on to your trading position for months or years without worrying about margin calls or additional charges if the account falls negatively.
Cash and margin accounts are two trading account types that brokerage firms offer to their clients. Traders use these accounts to engage in different trading strategies and options, depending on the trader’s preference and style.
The margin account is usually riskier because it allows the trader to borrow money from the broker and sell stocks they do not own. Although leveraged trades can signify a trader’s gain, they signify their losses and can leave the trader indebted to the broker.
Therefore, the margin account must be treated carefully and only if you are experienced enough or have considerable capital to cover your losses and add more funds upon margin calls.
Which is better, margin or cash account?
Choosing the type of account depends on the trader’s style and strategy. It also depends on the trader’s experience and capital. Cash accounts are safer to trade with and easier to use, where you can only buy and sell securities you own or with enough cash. Margin accounts allow the trader to explore more trading opportunities with leverage and borrowing, but they are riskier.
What are the disadvantages of a margin account?
Margin accounts are considered riskier because they allow you to borrow funds from the broker and enter high-value trading positions with the broker’s leverage. However, if these positions fail, the trader will lose their money and owe the broker margin loan that needs to be repaid.
Should a beginner use a margin account?
Margin accounts are not usually recommended for beginner traders because they entail more complicated calculations and strategies than cash accounts. A cash account is more manageable for beginners and is a perfect trading option for risk-averse investors.
Why do people use margin accounts?
Investors use a margin account to enter trading positions with the broker’s money. For example, if a position requires $500 but the trader only has $50, they can use 1:10 leverage and open a trading position. Additionally, stock traders buy on margin to fund shorting, borrowing stocks from brokers and selling them before rebuying them when the price is lower.