Cash vs. Margin Accounts
A Cash Account requires you to deposit funds before making trades. Your buying power equals the amount of money you’ve deposited into the account.
Assume you deposit $100 into your Cash Account. If you wish to buy shares of a company, ABC, trading at $50 per share, you would need $100 available to buy two shares.
Your broker might charge a fee, or commission, to execute the trade. For example, if the broker’s fee is $10 per trade, you would need $110 in your Cash Account to buy two shares of ABC at $50 each.
After selling your shares, you must wait for the trade to settle—usually T+2 business days (Transaction day plus two business days)—before you can withdraw the proceeds or use them to make another purchase.
A Margin Account lets you leverage your positions by borrowing against the value of the assets in the account.
Margin is essentially a loan, and leverage is the advantage it provides. For instance, with a 2:1 leverage ratio, you could borrow two dollars for every dollar in your account. If your account contains $5,000, your broker might allow you to borrow $10,000. Keep in mind that brokers charge interest on margin loans.
If you have $5,000 in your Margin Account and a 2:1 leverage ratio, you could buy up to $10,000 worth of stock—double the amount you could buy with a Cash Account. If ABC shares are trading at $200, you could buy 50 shares. However, you’ll owe interest on the $5,000 you borrowed.
With a Margin Account, you can also short sell stocks. Short selling is selling a stock you don’t own, with the hope of buying it back later at a lower price to make a profit.
When you short sell, your broker lends you the stock, which you immediately sell. If the stock price drops, you can buy the stock back at the lower price and return it to your broker, keeping the difference.
But if the stock price goes up, you could face a margin call. This is a demand from your broker to deposit more money or securities to cover potential losses from the short sale. If you can’t meet the margin call, your broker can sell securities from your account without your approval.
Let’s consider two accounts, each starting with $5,000, and a broker that doesn’t charge commissions. The Margin Account has a 2:1 leverage ratio.
Week 1: Buying
Company ABC trades at $200 per share.
- Cash Account: Buys 25 shares ($5,000 / $200)
- Margin Account: Buys 50 shares (2 * $5,000 / $200)
Week 2: Selling With Price Increase
Company ABC trades at $300 per share.
- Cash Account: Sells 25 shares for $7,500. After T+2 days, the funds are available.
- Margin Account: Sells 50 shares for $15,000. The funds are immediately available.
Week 2: Selling With Price Decrease
Let’s imagine that instead of rising, the price of ABC shares falls to $100 in the second week.
- Cash Account: Selling 25 shares would only yield $2,500. You’ve lost half your initial investment.
- Margin Account: Selling 50 shares would yield $5,000. However, because you borrowed $5,000, you’re left with nothing from your initial investment. Plus, if the stock price fell drastically, you might owe more than your initial investment due to a “margin call,” when the broker demands additional funds to cover potential losses.