If you enjoy investing, chances are you have a brokerage account.
Typically, you start off with a cash brokerage account. You may also get the option to trade with margin.
While a cash brokerage account is as straightforward as it sounds, many people don't quite know what to do when they're offered margin on their accounts.
Here’s what you need to know to determine what type of account you have and how to choose what is best for you.
What Is a Margin Account?
A margin account is a type of brokerage account where you can borrow money to buy securities such as stocks, bonds and options.
You don’t have to have the cash upfront in order to make purchases.
Borrowing to trade
Since brokerage firms are lending you money -- often called margin loans -- to buy investments, the brokerage firm has more risk than a traditional cash account.
Because of this, brokers require you to apply to open a margin account.
Usually, brokerage firms will ask for information such as:
- your income
- net worth
- the amount of liquid assets
They may check your credit, as well.
Minimum capital requirements
At a minimum, most brokerages require investors to have $2,000 of cash or securities in an account to open a margin account.
Brokerages may request higher amounts, as well.
Initially, you must have equity of 50% to trade on margin.
To invest with $10,000 on margin, you must have at least $5,000 in cash or securities in the account. Brokerages may require more in some cases.
Based on this information, a brokerage firm will determine if it will allow you to start buying stock on margin with them.
The details of how your account will operate and what collateral you must put up to be able to trade may be outlined in a margin agreement.
Again, whenever you trade on margin, the broker lends you money.
Likewise, you’ll have to pay interest on the margin loan. In an ideal world, you’d make more money trading on margin than the interest charged.
However, life doesn’t always work in ideal ways.
You could end up losing money on the investments you make and have to pay interest on the money you borrowed. This is why trading on margin is considered risky.
What Are Cash Accounts?
In a cash brokerage account, you must use cash to pay for the securities you want to buy in your brokerage account.
You aren’t able to borrow money from the brokerage to trade on margin.
This makes cash accounts much easier to understand.
There are no margin agreements and you don’t have to pay interest in order to trade securities.
If you don’t have the cash to make a purchase, you can’t do it. Instead, you must wait until you have enough cash in the account to do so.
Margin Accounts vs. Cash Accounts
As you can tell, margin accounts and cash accounts are two very different ways to invest.
Margin accounts allow you to potentially have more money in investments, but you’re borrowing that money.
With that in mind:
Margin exposes you to a higher risk of bigger losses. It also allows you to earn more from the gains.
Cash accounts, on the other hand, limit you to investing the cash you have on hand. You don’t have to worry about margin calls, but your gains are limited to the amount you’re able to invest.
Thankfully, your losses are also limited to what you’re able to invest.
Margin Call: What Happens When Your Account Value Falls Too Much
When you’re trading on margin and the value of your account falls, brokers are at risk.
They let you borrow money but the securities that back up the loan may now be worth less than the amount you owe on the margin loan.
In these cases, your brokerage firm may make a margin call.
Essentially, this is the broker requiring you to either deposit more cash or more securities into your account to reestablish the minimum value required in your agreement.
The federal requirement for a margin call is when your equity falls below 25%.
However, brokerages may have higher limits themselves, such as 30%.
In most cases, you have a certain number of business days to reestablish the minimum value required. Even so, it can be difficult to do this if you don’t have the cash laying around to put into your account.
When you can't pay the margin call
If you can’t pay the margin call, your broker may close out (i.e., sell) your investments to properly fund the account.
This is not ideal, as the brokerage may close out different investments than you would have.
This can cause havoc for tax purposes and your investment strategy.
Pros of Trading on Margin
Maintain cash liquidity
On the positive side, trading on margin allows you to keep your cash available in case you need it for another purpose.
If an emergency pops up, you wouldn’t have to immediately sell your investments to cover the costs.
You should strongly consider whether you should continue trading on margin if your cash buffer is gone.
A faster way to build your portfolio
Trading on margin can allow you to grow your portfolio faster.
If you initially only have enough money to purchase a couple of stocks, trading on margin may allow you to diversify and purchase a couple of additional positions.
This could mean you don’t have enough money to start investing in individual stocks if you can’t properly diversify without trading on margin.
Potential for bigger returns
The biggest benefit to trading on margin is your winners can become bigger winners.
By trading on margin, you can purchase more of an investment to participate in gains even more. This is a double-edged sword, though.
More on that in a second.
Cons of Trading on Margin
Trading on margin is complex on its own. Some traders make margin trading even more complex by using margin for options trading.
Adding complexity is definitely a downside.
While some traders will say there are options strategies that lower risk, combining options trading and margin accounts can be even riskier.
Risk of major losses
When you invest on margin, you’re investing with borrowed money.
This can cause a great amount of stress, especially if your investments aren’t performing as planned.
Stress can have negative health impacts that make your investment losses even more negative.
Trading on margin can result in getting in over your head quickly.
Just like investment gains can increase by trading on margin, the double-edged sword means losses can be amplified, as well.
What may have been a reasonable loss in a cash brokerage account could turn into a massive loss if you bought more shares of the investment by trading on margin.
Margin call rules
Another huge disadvantage of trading on margin is margin calls.
If your account value drops too low, you may end up scrambling to find a way to satisfy the margin calls.
This can get very expensive.
Tips on Using Margin Wisely
If you want to invest using a margin account, there are ways you can attempt to do so in a safer manner.
That said, investing on margin is risky.
Don’t do it unless you fully understand the consequences of doing so.
Know the margin rules for your specific brokerage account
Before you start trading on margin, make sure you understand exactly how your margin account works.
Understand when margin calls will happen, how much you have to pay on margin and everything else about your account.
Maintain a safe trading strategy
Next, build a trading strategy to help you not get into trouble.
Establish proper checks and balances to make sure your trading doesn’t get out of control. Have a short-term and long-term plan.
As part of your strategy, make sure you know when it’s time to cut your losses and get out of a bad investment. You don’t want to put yourself in a position where you can’t afford to cover the margin loan.
You’ll want to carefully consider the assets you buy on margin. Don’t focus on investing in risky assets trying to hit a home run.
Instead, focus on reliable assets that are fundamentally sound.
Be prepared for margin calls
Do your best to avoid falling into a position where a brokerage would have to make a margin call.
Margin calls can put you in tricky situations that require selling assets you wouldn’t otherwise sell.
Ideally, it’s nice to have the cash set aside to cover a margin loan if the worst-case scenario happens.
In this case, you’d mostly be using margin trading as a way to keep your cash accessible at the cost of paying interest on the margin loan.
Don't get too ambitious
Finally, if you’re getting started trading on margin, don’t get in over your head.
Instead, start with a very small investment to get an idea if trading on margin is for you without risking a large amount of money.
Investing on margin isn’t for the majority of people. If it seems too risky for you, it probably is.
Ultimately, you must decide if a cash or margin account is right for you.
For the vast majority of everyday investors, a cash account will likely be your best bet.
However, the more advanced traders may want a margin account for cash flow purposes.
If you’re unsure which is best for you, consider talking to a fiduciary financial advisor. They can help you understand the pros and cons based on your specific situation.