When you enter the world of trading, you’ll come across a number of terms that you need to understand.
A cash account is a type of account where you spend full funds on the securities you buy. On a cash account, you do not borrow funds from your broker to make transactions.
All your gains or losses are purely using your own funds.
The practice of posting collateral that can be used to open positions that are larger than your trading funds is referred to as margin trading.
A margin account is a type of account that you create when you borrow funds from your broker. The account is collateral for investing (margin securities).
Some brokerage firms allow you to have a margin account and a cash account at the same time.
How Margin Trading Works
Let’s say you buy a stock for $50 and the stock price rises to $75. If you buy the stock with a cash account and pay for it in full, you will get a 50 percent return on your investment. Your $25 profit is 50% of your initial $50 investment.
If you buy the stock on margin – depositing $25 of your own capital and borrowing $25 from your broker – your $25 profit is 100% of your initial $25 investment.
Note that this example does not take into account the interest you have to pay to your broker on the $25 margin loan you used to buy the stock.
Margin Advantages and Disadvantages
Margin accounts are offered by brokers that allow investors to borrow money to buy securities.
Brokers charge investors interest for the right to borrow money and use securities as collateral.
Margin can be a valuable tool in the right situation, but your risk of gain is as great as your risk of loss.
If your stock falls and you are below your broker’s borrowing threshold, they have the right to issue a margin call.
A margin call agrees that your broker can sell your position without your permission to recoup the investment.
If your broker sells your shares after the price has fallen, then you lose the opportunity to recoup your losses if the market turns positive.
Alternatively, the broker may ask you to deposit additional capital into your account to get you back above the threshold.
Due to its association with interest, margin is often used in short-term investments. Margin holds a positive value, in the sense that it works well when the value of the investment rises. However, it is dangerous if the value goes down.
Therefore, using a margin account is more suitable for investors who have extensive knowledge of risk and trading as a whole.
The use of margin is inseparable from leverage. Learn how leverage works.
Before
opening a margin account Before opening a margin account, you can protect yourself by:
- Know how margin accounts work and what happens if the price of securities bought on margin falls.
- Understand that your broker charges you interest for borrowing money and how this will affect your total return on investment.
- Understand that not all securities can be bought on margin.
- Ask your broker if trading on margin is right for you considering your financial resources, investment objectives and risk tolerance.
2. Read your margin agreement
To open a margin account, your broker will ask you to sign a margin agreement. The margin contract may be part of your general brokerage account opening agreement or it may be a separate agreement.
The margin agreement stipulates that you must comply with the margin requirements set by regulators, the relevant stock exchange and the company you are managing your margin account with. Be sure to read and review the agreement carefully before signing it.
Review the agreement carefully to determine what notice, if any, your brokerage firm must provide to you before selling your securities to collect the funds you have borrowed or making any changes to the terms and conditions. In general, companies must provide customers with at least 30 days’ prior written notice of any changes to the interest calculation method.
Conclusion
Always be cautious and wise in your steps, this is a sign that you are fully prepared to achieve the success you dream of.
Don’t be tempted by big numbers, but focus on consistency in collecting profits.
As the saying goes, little by little becomes a hill.
However, you also know how far you can go. If you are confident in your abilities and ready to take bigger risks, why not?
You define your reality.