Online brokers and brokerage firms are highly popular these days because they offer secure interfaces that allow fast trading, trend, and predictive analysis, and the ability to borrow funds or trade on margin.
Online stock accounts use specific terminology and display common figures that could be confusing to a novice trader. Three of the most common terms and figures that every newcomer should know are account value, cash value, and purchasing power.
- Brokerage trading accounts have three types of value: account value, cash value, and purchasing power.
- The account value is the total dollar worth of all the holdings of the account.
- The cash value is the total amount of liquid cash in the account, available for immediate withdrawal or use.
- Purchasing power is the amount an investor has to buy securities, consisting of cash, account equity, and available margin (money they can borrow).
- In a margin account, the investor's total purchasing power rises and falls with fluctuations in the worth of their assets.
The account value, also known as total equity, is the total dollar value of all the holdings of the trading account; not just the securities, but the cash as well. This figure is calculated by adding the total amount of cash in the account and the current market value of all the securities and then subtracting the market value of any stocks that are shorted. It is essentially the worth of all positions if they were to be liquidated at a particular point in time.
The cash value, also referred to as the cash balance value, is the total amount of actual money—the most liquid of funds—in the account. This figure is the amount that is available for immediate withdrawal or the total amount available to purchase securities in a cash account.
The final figure, purchasing power or buying power, is the total amount available to the investor to purchase securities. This amount overlaps to some degree with cash value, but it goes further. It includes both the available cash on hand along with any available margin.
The purchasing power of an investor depends on the amount of equity in the account, which is the total value of the stocks and other investments held in the account minus any outstanding margin loan. Buying power, or purchasing power, also depends on the type of account the investor has. If the investor has a margin account, their purchasing power will almost always be greater than the cash value.
Purchasing Power and Margin Accounts
Margin is borrowed money, specifically, money borrowed from a brokerage firm used to buy stocks or investments. It is the difference between the total value of securities held in the investor's account and the loan amount from the broker. If an investor buys on margin, they are using the borrowed money to buy securities.
Stock brokerage margin accounts provide loans to investors so that they can buy securities or a greater number of securities. The loans are called margin loans, and they increase the stock purchasing power of the investor along with the potential to make greater profits or losses on those investments.
Limits on Purchasing Power
The Securities and Exchange Commission (SEC) limits the value of stocks that an investor can purchase using margin. That limit is two times the equity in the margin account. Basically, the investor can borrow 50% of the cost of stocks. If the account is a pattern day trading account, which refers to traders or investors that execute four or more day trades during five business days, the limit increases to four times the equity in the margin account—but for day trading only.
The Risks of Buying on Margin
As the stocks in a margin account increase in value, so does the account's and the investor's purchasing power. If the stocks go down in value, so will the purchasing power. If an investor uses their full margin purchasing power to buy stocks, they will be at twice the leverage in a margin account. Thus, if an investor's stocks go up by 10%, the investor gains 20% on their equity. A decline of 10% will mean a 20% loss. For day traders, the purchasing power gains and losses are multiplied by four.