You must open a brokerage account when you are ready to start investing in stocks. One important question brokers will ask is whether you want to open a cash account or a margin account. There are important differences between these account types and how they work in stock trading transactions.
The cash account is simple. With a cash account, you pay in full for your stock purchases within three business days after the transaction date. If you bought $10,000 worth of stock on a Tuesday, you must give the broker a check for $10,000 plus the broker’s commission by Friday. The three-day “settlement” interval is set by federal securities regulations. Any investor can open a cash account. You can use a cash account to buy any stocks, bonds and mutual fund shares traded on any exchange.
A margin account allows you to buy stocks on credit. This is commonly known as buying on margin. You still must complete your purchase within three business days, but you only put up 50 percent of the purchase price in cash. Your broker extends you credit for the other half of the purchase price. If you buy $10,000 worth of stock, you only have to deposit $5,000 with the broker. The broker lends you the other $5,000 and holds the $10,000 in stock as collateral to secure the loan. When you sell the stock, you pay back the broker’s $5,000 loan plus interest and keep the balance.
Federal securities regulations for margin accounts prohibit buying stocks on margin for individual retirement arrangements, Uniform Gifts to Minors accounts or fiduciary accounts such as trusts. These transactions require 100 percent cash. You also can’t use a margin account for stock purchases of less than $2,000, buying stocks in their initial public offerings, buying stocks trading under $5 a share or for stocks trading anywhere other than the New York Stock Exchange or the NASDAQ National Market.
Margin Pros and Cons
A margin account gives you leverage. With a 50 percent margin, you own twice as much stock as you would have owned had you paid 100 percent cash. If the stock rises, your percentage gain is twice as big. But if the stock falls, your percentage of loss doubles. Additionally, federal regulations require that you maintain a minimum ratio of stock value to loan amount. If declining market values of your margin stock send the ratio below the required minimum, your broker must issue a “margin call” that requires you to put up more cash as collateral. If you don’t have the cash, the broker can sell sufficient amounts of your margin stock to restore the minimum value-to-loan ratio. Stock exchanges and brokers can set a minimum ratio above the federal requirement.
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