2024.12.27 2024.12.27
Margin Account vs. Cash Account

Oleg Tkachenkohttps://www.litefinance.org/blog/authors/oleg-tkachenko/

To trade securities, you need to open an account with a brokerage company. Stock brokers offer two main types of accounts, cash accounts and margin accounts. Trading on a cash account with securities taken on credit is excluded, and on a margin account, it is possible upon making a preliminary pledge. In other words, in the first case, you sell only those stocks that you bought earlier. In the second, you can sell shares even if you do not have them, use the purchased shares as collateral for a loan, and use trading on margin, that is, trading with leverage.

What is the fundamental difference between margin and cash accounts? Are there any differences between trading on a cash account and a margin account without a broker loan? What is the difference between trading conditions for both types of accounts? What are their advantages and disadvantages? Which account is better for your trading strategy? Are there alternative stock trading options? Let us find out!

Major Takeaways

• Margin Account vs. Cash Account: the choice depends on your trading goals, experience, and risk tolerance.
• A margin account allows you to use leverage, which increases the volume of trades and potential profits.
• A cash account limits you to using the cash that you have on hand, while reducing the risks associated with borrowing.
• Margin trading is suitable for experienced traders who can tolerate an increased level of risk.
• Beginners may want to start with a cash account to avoid large losses due to lack of experience.
• When trading on a margin account, it is important to keep an eye on margin levels to avoid margin calls and forced closing of your positions.

What is Margin Account?

A margin account is an account that allows traders to borrow money and other financial assets from a broker to trade in the financial markets. The trader deposits the collateral amount on the account, stipulated by the broker’s trading conditions, after which they can conduct trading on margin in assets borrowed from the broker.

How does Margin Account work?

A margin account works in the following way:

Selling short

For example, you believe the price of a stock is likely to fall, but you don’t have this stock. You can borrow these stocks from the broker and sell them. When the stock drops in price, you can cover your shorts by entering longs at a lower purchase price and make a profit.

Leverage

You assume that the stocks you are interested in will rise to 10 USD in a few days. You only have money to buy 5 shares, so your potential return on investment is 50 USD. Then you take money in margin loans from a broker; that is, you use leverage. Its value, for example, 1:10 means that you can open a trade with 10 times the volume and buy 50 shares. In this case, your profit will be 500 USD. After selling the shares that have risen in price, you return the loan to the broker.

In theory, trading on margin allows you to increase the potential profit. However, trading with borrowing money suggests rather high risks in practice.

Margin Account Requirements

Margin account requirements can be divided into two groups: the requirements of regulators and the requirements of the broker.

Legal requirements

The financial industry regulatory authority classifies trading on margin as trading with a high level of risk, which inexperienced traders may underestimate. Therefore, certain requirements are set for margin accounts, along with advisory or brokerage services. For example, in the US, the Securities and Exchange Commission or the SEC assigns PDT status to traders.

PDT (Pattern Day Trader) – the status of a trader, determined by the rules of US stock trading regulation. A trader is considered PDT if they make more than 3 intraday trades in 5 business days. Both opening and closing positions within one trading day are taken into account. If a trader obtains PDT status, they must have at least 25,000 USD on a margin account. If the account does have the required amount, the trade can’t execute day trades until the required threshold is reached.

Differently put, if you want to enter more than 15 trades a week on your margin account, deposit at least 25,000 USD. It doesn’t matter whether you use a broker’s loan or not – these are the conditions.

Broker requirements

The broker’s requirements can be set in accordance with the law and in accordance with its internal policy. The main requirements relate to the level of initial and maintenance margin. For example, the SEC has a 25% initial margin requirement. That is, the trader must have at least 25% of the amount of the transaction on the account.

Also, brokers require compliance with the minimum level of maintenance margin. If, due to the current loss, the investor’s minimum equity falls below the level set by the broker, the broker stops the transactions out. 

Brokers can set minimum deposit cash requirements. For example, in the US, FINRA requires that the minimum capital for a margin account must be at least 2,000 USD.

Who Margin Accounts Are Ideal For

Margin accounts are suitable for traders who:

• Actively use trading on margin, buy new positions, and sell short, making profits from both the price rise and fall. These traders often sell short and use leverage when they see an opportunity to raise the potential profit;

• Do not risk too much and control their risks and emotions;

• Conduct options trading, where the underlying assets are shares.

A margin account is right for you if you are an active trader working with scalping strategies and intraday trading systems, know the rules of risk management and follow them, and know how to calculate pip value and stop lengths. 

What Are The Benefits of Margin Account?

The advantages of a margin account include

• Leverage. A margin account allows a trader to trade with borrowed money, which increases their buying power and allows them to open larger positions. The larger the position, the greater the profit. Leverage can increase the base deposit by several dozen times, but regulators impose restrictions on its maximum value, which depend on the trader status.

• Short trades. You can sell stocks that you do not own.

• No settlement period. Positions closed on a margin account are executed instantly. After ordering the broker to sell the asset, money is immediately credited to your account.

• The ability to use your own shares and money as collateral.  

Although a margin account provides a number of advantages, it often involves increased risks.

What Are The Risks of Margin Account?

The main risks of a margin account are:

• The risk of losing money and stopping out your trading positions. Leverage is generally used to reduce collateral. It is also often used to increase transaction volumes. The greater the amount of the purchased asset, the greater the potential profit. However, the price can go in the opposite direction, and the trader will receive a larger loss instead of a larger profit. In this case, the broker will ask for cash to be deposited into the account (margin calls occur) or will forcibly close transactions (stop out).

• Additional swap charges. If leverage is used to increase the position’s size, then the swap’s cost, which is charged on the nominal value of the position, also increases. The higher the trade volume, the higher the swap. This point is often overlooked by beginner margin traders.

• The risk of losing more money than actually is on the account. Some brokers have negative balance protection, a mechanism that automatically closes trades as soon as the account margin balance reaches zero. If it is not provided for by the trading conditions, the trader runs the risk of “going negative”. The broker can recover the debt in court if the trader does not repay it voluntarily.

• The risk of liabilities on borrowed funds. If a trader opens a position using borrowed funds, then they are obliged to pay interest on them. These additional costs are specified in the trading conditions. Some brokerage firms do not charge interest on loans.

• The risk of changing margin trading rules. Brokers have the right to change the rules of trading on margin at any time, which may affect the purchasing power of a trader. For example, a broker may decrease leverage when volatility rises abnormally. If a trader missed the broker’s warning, he risks getting a margin call and a stop-out.

The main risks of trading on margin come down to a trader’s possible error, which will lead to a loss, an error due to ignorance, or a psychological reason. In the first case, the trader may not be able to calculate the amount of possible loss depending on the volume of the transaction and the pip value. In the second, a trader may open a position with the maximum volume in pursuit of greater profits, violating risk management rules.

What is a Cash Account?

A cash account is an account where all transactions must be made within the available cash balance or assets that are available. How does a cash account work? The cash account works like this: if a stock costs 100 USD, and there are only 90 USD in the account, you cannot enter a trade. If a trader has 50 shares, they cannot sell more.

Cash Account Requirements

Regulators have fewer requirements for cash brokerage accounts. The main limitation is set by brokers; it is the requirement for a minimum deposit. For one brokerage firm, it can be 50 USD -100 USD; for others, it can be more than 1000 USD. The trader cannot withdraw or transfer money until the settlement is made in accordance with the T+2 trading mode.

Cash Account Settlement Period

Cash accounts have the so-called settlement period. This is the time that elapses from the transaction moment until the money is credited to the account. The settlement period is T+2 on stock exchanges. Differently put, the time between the trade date and the settlement date is two days. During this period, the buyer of the asset must pay its cost to the seller, and the seller must transfer the asset to the buyer.

Example. You sell shares on Monday. The settlement period is two days, including the day of the transaction. This means that the money on your brokerage account only appears on Wednesday. Similarly, with the purchase. You will become the full owner of the purchased asset only in two days. Therefore, you cannot use the money for the next trades on Tuesday.

There are several calculation modes: Т0, Т+1, Т+2. Which one applies is determined by the rules of the exchange. The T+2 mode is also available on margin accounts. Here, unlike a cash account, it is beneficial for the trader since it allows you to get one free day of holding a margin position.

Who Cash Accounts Are Ideal For

Cash accounts are suitable for the following types of trades:

• Conservative traders who are willing to limit their risks. When a trader has several transactions open for different assets, they can miss some little things, like a triple swap, or make a mistake when calculating the position volume. Since there are no borrowed funds, the trader risks only their own funds;

• Traders who make very few trades and prefer long-term investment. Borrowed funds are needed when you urgently need to enter a trade but don’t have your own money. In long-term investment, borrowed funds are not needed;

• Inexperienced traders who have not yet learned how to calculate the level of risk, so trading with borrowed money is not recommended for them;

• Everyone who, for some reason, does not want to get involved in trading with loan funds.

What Are The Benefits of Cash Accounts?

Below, the advantages of cash accounts are listed:

• You cannot lose more money than you have. You can lose the entire deposit only if the asset is completely depreciated. In this case, there will be no negative balance.

• You can’t receive margin calls or stop-outs. You can wait out a drawdown. You also can an asset without the risk that your trade will be stopped out. 

• Flexibility. On a cash account, a trader can buy and sell securities in any amount that they can afford in cash. On a margin account, the broker has the right to require a minimum volume of a trading position.

• Low commissions. Cash accounts can have lower commissions than margin accounts because the trader does not use borrowed funds and does not pay interest on them.

• Holding back emotions. A trader cannot use more money than they have. Therefore, there is no temptation to use a double or quadruple loan.

Also, the advantages include the absence of legal restrictions. For example, in the US, regulators set minimum margin requirements for margin accounts and tie the number of transactions to the amount of the minimum cash deposit (PDT rule). There are no such restrictions on cash accounts.

What Are The Drawbacks of Cash Accounts?

Cash accounts also have a number of disadvantages:

• Limited opportunities. A trader can only trade with their own money. Short selling is excluded as an investor can only sell the asset they have on hand.

• There is a settlement period. The money will be credited to the account only after 2-3 business days after the sale of the asset.

• No leverage. A trader misses the opportunity to earn on a temporary drop in the market value of an asset.

   

The main disadvantage of cash accounts is that their potential profit is less than on margin accounts due to the lower risks. 

Margin Account vs Cash Account – What Is The Main Difference?

Let us consider the differences between margin accounts and cash accounts in the table below:

Minimum deposit requirements

The requirements for the minimum deposit on a margin account are set by regulators to limit the risks for the trader. Depending on the country, it can be at least 2,000 USD. Additionally, it may be required to pass an exam to obtain the status of “Qualified Investor”. There are no restrictions on cash accounts; the size of the minimum deposit is set by the broker.

Margin requirements

Margin equity is the portion of funds in a margin account that a trader owns (versus funds they’ve borrowed) expressed as a percentage. Since there is no borrowed money in cash accounts, there are no margin requirements. On margin accounts, the requirements are set to:

• Initial margin – the amount that must be on the account before opening a position. Usually, it is 25%-50% of the transaction amount;

• Minimum maintenance margin – the amount needed to maintain an open position. 

Leverage

Leverage is offered only on margin accounts. The maximum risk is associated with using leverage selling short. Differently put, a trader sells an asset without owning it and increases the position volume using borrowed funds.

Selling short

Short positions are Impossible on cash accounts and possible on margin accounts. On a cash account, one can only long, buy securities or other assets betting on a price rise.

Negative balance

This situation is possible on margin accounts, despite the stop-out conditions. For example, when opening a new session with a gap, charging a triple swap, and so on. The negative balance must be paid off. Otherwise, the broker has the right to demand this through the court.

Settlement period

Money is credited instantly after the transaction is made on a margin account. In cash accounts, money is transferred in two or three working days following a transaction. Settlement periods T0, T+1, ‎and T+2 are introduced to ensure the security of transactions. 

Security-based loans

On margin accounts, it is allowed to receive a loan against purchased stock assets. On cash accounts, this option is not provided.

Speed of increasing profit or loss

On margin brokerage accounts, a trader can increase their position through leverage. If the transaction volume is doubled with leverage, the potential profit or loss will also double. Also, a trader can earn on short trades. There is no such option for cash accounts.

Trading strategies

Popular trading strategies for margin accounts are:

• Scalping – high-frequency trading, also including short trades.

• Intraday trend strategies with a consistent increase in the volume of the transaction due to leverage in the presence of a stable trend;

• Swing trading – trading on corrections with opening opposite positions. A short position is opened on a correction to an uptrend, so a trader profits from price swings in both directions. 

   

Also, on a margin brokerage account, you could try the strategies of trading on pumps, averaging, and hedging. 

Trading strategies for a cash investment account:

• Position trading involves making money on long-term uptrends. The strategy is well suited for trading stock indices, buying shares of companies from the retail sector with a constant demand for products. It is possible to form an investment portfolio and receive annual percentage yield, dividends;

• Fundamental analysis trading. It means opening long positions just before the release of financial statements or the distribution of dividends. 

If you prefer active trading, choose a margin account. A cash account is suitable for those who make very few trades and use conservative strategies.

Securities in Your Account

In the cash account, one can purchase securities, and they are exclusively at the disposal of the trader. Nobody else has the right to do anything with them. In a margin account, the broker can lend the shares you bought to another trader who opens a short position. All this is stipulated in the contract and carried out through the so-called REPO operations, for which the trader will receive a commission as the owner of the shares. Such moments carry certain risks, but they are all manageable.

Advantages of margin accounts over cash accounts

The main advantages of margin accounts are flexibility and wide opportunities. Seeing a good moment to buy or sell an asset, a trader can use the broker’s borrowed money, agreeing to certain risks. Regulators try to reduce the risks by the requirements for the minimum deposit, margin level, and qualification of the trader. Most of the margin requirements apply to traders working with stock assets on the US and European stock markets. The alternative is trading on margin CFDs (Contracts for Differences).

Benefits of CFD trading

• No strict requirements for the minimum initial investment; the minimum deposit is from $50 to $100;

• Leverage is provided regardless of trader qualification;

• There is negative balance protection. CFD trading accounts combine the benefits of a margin and cash account;

• Instant transaction execution. Any asset is bought or sold in a few milliseconds. There is no T + 2 settlement mode unless otherwise provided by the terms of the exchange;

• Over 200 trading assets, including cryptocurrencies. 

However, trading CFDs carries the same risks as trading on margin. They must be taken into account when developing a risk management system. Traders can try their hand and learn how to make money on the difference in prices using the LiteFinance demo account for free and without registration.

Conclusion

Margin account versus cash account – key takeaways:

• A cash account is an account on which a trader opens transactions only with their own money. Only long positions are opened;

• The advantages of a cash account are no temptation to use a loan, no account requirements; you can not lose more cash than you have;  

• Shortcomings of the cash account are fewer opportunities to profit, T + 2 settlement period;

• A margin account is an account on which trading one can trade using the broker’s borrowed funds; leverage is available. A trader can increase positions with borrowed money and sell assets that they do not actually own;

• Advantages of a margin account include the ability to implement any strategy, including short-term ones, and more opportunities to make profits;

• The disadvantages of a margin account are a number of requirements from regulators and a high entry level.