Cash Account vs. Margin Account: An Overview
Investors looking to purchase securities can do so using a brokerage account. The two main types of brokerage accounts are cash accounts and margin accounts. The main difference between these two types of accounts are their respective monetary requirements.
- The two main types of brokerage accounts are cash accounts and margin accounts.
- Cash account requires that all transactions must be made with available cash or long positions.
- Margin accounts allow investors to borrow money against the value of the securities in their account.
- If you give the brokerage firm permission, shares held in a cash account can also be lent out to other interested parties, including short sellers and hedge funds.
- For a margin account, the securities in this account may be lent out to another party at any time without notice or compensation to the investor if they hold a debt balance (or a negative balance) on the account.
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. These accounts are fairly straightforward.
If you give the brokerage firm permission, shares held in a cash account can also be lent out to other interested parties, including short sellers and hedge funds. This can be a source of additional gain for an investor. This process is called share lending, or securities lending.
If you have a cash account with securities that are in demand for short sellers and hedge funds, you can let your broker know that you are willing to lend out your shares. If there is a demand for these shares, your broker will provide you with a quote on what they 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. For example, your broker may give you an 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.
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. When borrowing capital or securities, the borrower is required to pay fees and 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 most attractive securities to lend are those that are the hardest to borrow for short selling (which usually means companies with a small market capitalization or thinly traded stocks). Shares that are already heavily shorted or have fallen in price may also be attractive for lending.
This type of service is not automatically provided by all brokers, and even those that do provide this service may also require a minimum number of shares or dollar amount.
A margin account allows an investor to borrow against the value of the assets in the account in order to purchase new positions or sell short. Investors can use margin to leverage their 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 in the form of 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. This rate can be quite high.
For example, an investor with a margin account may take a short position in XYZ stock if they believes the price is likely to fall. If the price does indeed fall, they can cover their short position at that time by taking a long position in XYZ stock. Thus, they earn a profit on the difference between the amount received at the initial short sale transaction and the amount they paid to buy the shares at the lower price (less their margin interest charges over that period of time).
In a cash account, the same investor in this scenario must find other strategies to hedge or produce income on their account (since they must use cash deposits for long positions only). For example, they may enter a stop order to sell XYZ stock if it drops below a certain price, which limits their 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. A margin call is a demand for a deposit of more cash or securities to bring the account value back within the limits. The client can add new cash to their account or sell some of their holdings to raise the cash.
Margin privileges are not offered on individual retirement accounts because they are subject to annual contribution limits and this requirement impacts the ability to meet margin calls.
For a margin account, the securities in this account may be lent out to another party, or used as collateral by the brokerage firm, at any time without notice or compensation to the investor if they hold a debt balance (or a negative balance) on the account. 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. They are typically either 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 margined stocks from a brokerage firm. The brokerage firm may also pledge the securities as loan collateral.
Additionally, if an investor's margined shares pay a dividend but are lent out, you do not 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 may also lose your voting rights.