Cash vs. Margin Accounts - Lightspeed

Introduction: Cash versus Margin Account

Cash and margin accounts are the two main types of brokerage accounts, and which one you choose to pursue can significantly impact your trading experience. In a cash account, all transactions are based on your current available funds, while margin accounts, much like a loan, allow the investor to borrow additional capital. Each type of account possesses advantages and disadvantages that must be considered before making your decision. In this blog, we will explore the fundamental differences of each account, while considering their distinct benefits and drawbacks. It is here that you will decide which account best matches your financial objectives. Whether you are a novice or a seasoned investor, understanding the dynamics of cash and margin accounts is essential when navigating the intricacies of the finance world. Join us to learn how you can strategize the best course of action to meet your investment objectives.

What is a Cash Account?

A cash account is a straightforward, simple investment approach where investors buy and sell securities with their available cash balance. Here, you can only invest the money deposited to buy and sell securities. For example, if you deposit $10,000, you can only buy and sell with this same 10k. To acquire additional securities, you must deposit supplemental funds. Cash accounts are commonly used by more conservative investors who crave financial stability and prefer to avoid the risks associated with margin trading.

Benefits and Drawbacks of a Cash Account

One of the main benefits of a cash account is that your losses are capped at the amount invested. If you invest $10,000, you can only lose $10,000. Cash accounts also have no fees to hold the positions that typically accompany margin accounts. Additionally, because there are no margin calls in a cash account, investors can wait for the stock to recover in price and avoid selling for a loss. Cash accounts are typically more easily approved because investors are only trading with their available cash.

One drawback of a cash account is that your investments are bound by your available cash, limiting the potential for greater gains. Although there is less risk of a loss, you may not have the same leverage in your cash account that you would in a margin account. There is also no opportunity for short selling (a strategy where you profit from falling stock prices) in a cash account, and thus if you believe a stock price has the potential to decrease, you would not be able to take advantage of the stock price drop. Further, funds traded in a cash account also have to complete a cash settlement cycle before they are returned for available use. This can limit trading frequency and delay investment opportunities.

In Summary: Benefits and Drawbacks of a Cash Account

Benefits

• Offers simplicity for the more conservative investor

• Losses are capped at the amount invested

• No fees to hold positions

Drawbacks

• Limits investment amount

• No short selling

• Funds have to complete a cash settlement cycle before they can be returned for available use.

What is a Margin Account?

A margin account is a type of account that allows you to borrow additional funds from the brokerage firm to purchase securities. This borrowing ability is what distinguishes it from a cash account because investors are not limited by their available cash. For example, you might deposit $10,000 cash and also borrow $10,000, so that your account now has $20,000 to invest.

Benefits and Drawbacks of a Margin Account

The most significant advantage of a margin account is the ability to leverage your investments because you are not confined by the money in your cash account. This gives you the ability to buy more shares or contracts than you would have been able to with only your available funds. Consequently, there may be potential for greater returns if the market moves in your favor. Margin accounts also allow you to engage in short selling. This is a strategy where you sell borrowed securities with the expectation of buying them back at a lower price, enabling you to profit from falling markets. Additionally, you can reuse funds after you close the position the same day, whereas with cash trades you must complete the cash settlement cycle (T+2 for stocks, T+1 for options). In some cases, a margin account is necessary depending on the type of account for which you are looking. If you wish to open a pattern day trading account (PDT), a margin account is needed to reuse the funds intraday. To be designated as a PDT, this account must also have a 25k balance and thus you need a margin account to have the ability to actively trade and reinvest the funds throughout the day. Further, advanced trading strategies would be permitted in a margin account that would not be available in a cash account such as options spread trading or writing uncovered options.

One noteworthy drawback of a margin account is the potential for magnified losses. When you invest borrowed money, you risk losing more than your initial capital. Another disadvantage is the interest rates that accompany the borrowed funds. Margin calls can hinder financial growth because they require you to deposit funds or sell assets if your securities fall below the maintenance margin (the minimum equity required by a brokerage firm to maintain a position held on margin). If you fail to meet the margin call, the brokerage firm can force you to liquidate your positions.

In Summary: Benefits and Drawbacks of a Margin Account

Benefits

• Ability to invest beyond your cash deposit

• Potential for greater returns

• Allows for short selling

• Reuse funds same day

• Advanced strategies

Drawbacks

• High risk due to potential for magnified losses

• Interest rates

• Margin calls

Cash or Margin? Which Should You Choose?

When deciding between a cash or margin account you must consider your level of trading experience, financial situation, risk tolerance, and investment objectives. Cash accounts are ideal for novice investors who are looking for a more conservative trading approach. These traders desire security over high returns and may wish to avoid borrowing money. Margin accounts likely attract more seasoned investors who prefer to leverage investments by borrowing from the brokerage firm, and possibly achieving greater returns. In summary, it is important to appraise your financial plan before determining which type of account is most aligned with your investment goals.

*Please consider all possible risks and review disclosures to determine which account is most suitable.