If you want to buy securities, then you will need a brokerage account. However, if you are new to investing in this sector, you may not know that there are two main types of such accounts available. Before you choose one of them, it’s better to study their advantages and disadvantages and make a learned decision.
There are margin accounts and cash accounts. And they differ mainly with their respective monetary requirements. Let’s begin with margin accounts.
What are Margin Account’s conditions?
A margin account enables a trader to borrow against the value of the assets in the account. They can either purchase new positions or sell short with that money.
Traders can also use margin to leverage their positions and thus profit from both bullish and bearish moves in the market. Furthermore, you can make cash withdrawals against the value of the account, but only in the form of a short-term loan.
If you are seeking to leverage your positions, then a margin account can be very useful, as well as cost-effective for you.
When an investor creates a margin balance (debit), the outstanding balance becomes subject to a daily interest rate charged by the company. Typically, these rates are based on the current prime rate and an additional amount that the lending firm charges. As a result, this rate can be considerably high.
Besides, Margin accounts must always maintain a certain margin ratio. For example, if the account value plunges below this limit, the company issues a margin call for the client. A margin call is a demand for a deposit of cash or adding more securities that are needed to bring the account value back within limits. The clients have to either sell some of their holdings to raise the cash or just add money to their accounts.
The brokers usually don’t offer Margin privileges on individual retirement accounts as they are subject to annual contribution limits. That requirement impacts the client’s ability to meet margin calls.
What about Cash Accounts?
If investors have a cash account, they must make all transactions with available cash or long positions. It means that if an investor is buying securities in a cash account, they must deposit cash to settle the trade. They can also sell an existing position on the same trading day, but cash proceeds must be available beforehand to settle the buy order. Compared to margins, these accounts are quite straightforward.
Furthermore, with your permission, the brokerages can lend out your shares that are held in a cash account to other interested parties, including hedge funds and short-sellers. Investors can get additional profits from such dealings. That process is known as securities lending or share lending.
So, if you have a cash account with securities and know that they are in demand for short-sellers and hedge funds, you can give your broker permission to lend out your shares. After that, your broker will provide you with a quote on what interested parties would be willing to pay you for the ability to lend these shares.
If that amount is acceptable for you, your broker will lend your shares out to a hedge fund or a short seller for a higher rate. For instance, your broker may give you an 8% interest on the loaned shares but lend them out at 13%. So, it can be an excellent additional source of return.
Besides, this method allows you to keep your existing long position in the security, along with benefiting from its upward movement.
Short sellers and hedge funds’ demand for borrowing securities can be pretty high, especially on securities that are usually hard to borrow. However, consider that when borrowing securities or other capital, the borrower has also to pay fees and interest on the amount borrowed.