One of the first important decisions that investors must make when moving to an online broker is which type of trading account they need to open. Cash accounts and margin accounts each has their fair share of advantages and disadvantages. Here are several things you need to consider before choosing which is right for you.
Margin is essentially a loan from your broker that you can use to buy stocks and other assets. Typically, brokers will provide enough credit for a trader to borrow up to half of the purchase price of a stock. In other words, margin traders can buy twice as many shares of stock if they take full advantage of their margin limits.
Of course, like any other loan, margin traders must pay interest on whatever margin they use. In a cash account, traders are only allowed to buy or sell stocks and other assets using the cash they have in the account.
There are certainly many advantages to opening a margin account. As mentioned above, buying on margin allows traders to potentially double their position sizes, theoretically opening the door to larger returns. In addition, margin accounts allow short-selling, which gives margin traders more flexibility than cash traders. Margin traders also have access to a number of advanced option trading strategies that may not be available to cash traders.
Margin accounts also give traders more flexibility when it comes to settlement dates. Cash account traders must wait two business days for cash to “settle” in their account after making a sale. Margin traders can utilize their available credit to go ahead and make trades immediately after making a sale.
Margin accounts provide investors more flexibility, but they also come with unique risks. Margin fees can range from as low as 1 percent to as high as 10 percent annually depending on the broker and account size. Every cent paid in margin interest eats into investment returns.
Another disadvantage is that margin traders can be subject to what’s known as a “margin call” if the value of their assets declines 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 account’s equity value gets too low, 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 come at the very worst time to be selling stocks, when prices are at their lowest.
For long-term buy-and-hold investors, a cash account is the safer, simpler choice. For traders who intend to utilize advanced strategies and actively trade stocks on a daily or weekly basis, a margin account may be a better fit. Prior to opening either type of account, traders should make sure to read the fine print of any agreement they sign and fully understand the risks involved.
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