In a cash account, all transactions must be made with available cash or long positions. When buying securities in a cash account, the investor must deposit cash to settle the trade or sell an existing position on the same trading day, so cash proceeds are available to settle the "buy" order.
A margin account allows an investor to borrow against the value of the assets in the account to purchase new positions or sell short. In this way, an investor can use margin to leverage his positions and profit from both bullish and bearish moves in the market. Margin can also be used to make cash withdrawals against the value of the account as a short-term loan.
For investors seeking to leverage their positions, a margin account can be very useful and cost effective. When a margin balance (debit) is created, the outstanding balance is subject to a daily interest rate charged by the firm. These rates are based on the current prime rate plus an additional amount that is charged by the lending firm and can run as high as 10%.
An investor with a margin account may take a short position in XYZ stock if he believes the price is likely to fall. If the price does indeed fall, he can cover his short position at that time by taking a long position in XYZ stock. Thus, he earns a profit on the difference between the amount received at the initial short sale transaction and the amount he paid to buy the shares at the lower price, less his margin interest charges over that period of time. (If you are going to trade on margin, you need to understand the risks. For more, see our Margin Trading tutorial.)
In a cash account, the bearish investor in this scenario must find other strategies to hedge or produce income on his account since he must use cash deposits and long positions only. For example, he may enter a stop order to sell XYZ stock if it drops below a certain price, which limits his downside risk.
Margin accounts must maintain a certain margin ratio at all times. If the account value falls below this limit, the client is issued a margin call, which is a demand for deposit of more cash or securities to bring the account value back within the limits. The client can add new cash to his account or sell some of his holdings to raise the cash. Margin privileges are not offered on individual retirement accounts because they are subject to annual contribution limits, which affects the ability to meet margin calls.
What Happens to the Securities in Your Margin Account?
The securities in your margin account may be lent out to another party, or used as collateral by the brokerage firm at any time without notice or compensation to you, when there is a debt balance (or negative balance) on the account where you have accessed the margin funds. If the account is in a credit state, where you haven't used the margin funds, the shares can't be lent out.
The borrowers of stocks held in margin accounts are generally active traders, such as hedge funds, who either are trying to short a stock or need to cover a stock loan that has been called in. Investment firms that need an underlying instrument for a derivatives contract might borrow your margined stocks from your broker. The brokerage firm may also pledge the securities as loan collateral.
Additionally, if your margined shares pay a dividend but are lent out, you don't actually receive real dividends because you aren't the official holder. Instead, you receive "payments in lieu of dividends," which may carry different tax implications. When your shares are lent out, you can also lose your voting rights.
Share Lending in a Cash Account
If you give the brokerage firm permission, shares held in a cash account can also be lent out, which presents a potential source of additional gain. This process is called share lending
There can be a lot of demand by short sellers and hedge funds to borrow securities, especially on securities that are typically hard to borrow. Similar to a margin account, when you borrow capital or securities, you are required to pay interest on the amount borrowed.
Depending on market rates and the demand for the securities, the exact amount of interest charged for borrowing securities will vary (the harder to borrow, the higher the interest). The most attractive securities to lend are those that are hardest to borrow for short selling, which usually means small caps or thinly traded stocks, as well as shares that are already heavily shorted or have fallen in price.
This demand presents an attractive opportunity for investors with the securities in demand. If you have a cash account with securities in demand, you can let your broker know that you are willing to lend out your shares. If there is demand for these shares, your broker will provide you with a quote on what he/she would be willing to pay you for the ability to lend these shares.
If you accept, your broker will lend your shares out to a short seller or hedge fund for a higher rate and pocket the difference, as well as satisfy another customer's demand and generate commissions. For example, your broker may give you 8% interest on the loaned shares while lending out at 13%. Depending on the size of your position, it can be a nice additional source of return. This method also allows you to keep your existing long position in the security and benefit from its upward movement.
Depending on the broker, he/she may or may not provide this service, and may also require a minimum number of shares or dollar amount.