There are two main types of trading accounts you can have as a day trader or investor: cash and margin account. A cash account, also known as a brokerage account, lets you trade with the only money you have deposited.
A margin account, on the other hand, is one where you use borrowed money to maximize your returns.
In this article, we will look at what a margin account is, its advantages, and some of the biggest cons.
What is a margin account?
A key challenge that most people have is the lack of enough funds to day trade. This challenge is exacerbated by the fact that many assets have become highly expensive, with gold trading at >$2,000 and Berkshire Hathaway shares going for over $500k.
A margin account is one way that brokers make it possible for a person to trade all assets in a profitable way. It does this by providing them with leverage, which is a loan that helps them to maximize their profits.
A margin account is often compared to a credit card that lets you borrow, spend (in this case trade), and then return the money back. As you will see below, the use of borrowed money can amplify profits and also lead to substantial losses.
How margin accounts work
Margin accounts work in a relatively simple way. First, a trader creates an online account with a broker like Fidelity and Schwab. Second, they select whether they want a cash or a margin account.
If they opt for a margin account, they will need to select the borrowing power or leverage ratio. This ratio can be as small as 1:2 or as big as 1:1000.
In this case, if you select a ratio of 1:2 it means that your buying power will be double what you have. For example, if you have $200, then your buying power will be $400.
Types of margin
Margin accounts have some unique features, which tend to differ from one broker to another. First, there is the initial margin, which is the amount of buying power you are receiving.
Second, there is the maintenance margin, which is the amount of money you are required to maintain in your account. If your account falls to the maintenance margin, the broker will either stop it or ask you to add more money to your account,
It is worth noting that margin accounts are highly-regulated. In Europe, Australia, and some other countries, the maximum leverage one can use is 1:30. These countries were forced to add these requirements in a bid to reduce risks among investors.
Margin account example
The simplest way to think about margin accounts is this. Assume that you have $10,000, a stock is trading at $10, and you strongly believe that it will rise to $15. If you use a cash account, the maximum profit you will have is $5,000 and your maximum loss will be $10,000 (your account balance).
You can then decide to borrow another $10,000 to invest in the stock, giving you a buying power of $20,000. In this case, your gross profit will be $30,000 while your net profit will be $10,000.
The challenge with a margin account is that your account can become negative since you are using a loan.
Margin account and prop trading
As mentioned, margin account is the practice of using borrowing funds to optimize your profitability.
Another approach that people use is known as proprietary or prop trading. Prop trading is an approach where people trade using a company’s funds and then take a share of the profits.
Real Trading is a good example of a prop trading company in that it lets people from around the world create trading floors. It provides the technology and funds to these traders and then takes a small cut of their profits.
Related » Retail Trading vs Proprietary Trading Accounts
Margin account vs cash account
As mentioned, you can select between a margin account or a cash account. A cash account is the most basic one since it lets you trade with the only funds you have. If you have $10,000 in your account, you will only have the buying power of these funds.
Margin account gives you a loan or a line of credit that maximizes your profits. Most successful hedge funds use margin to a large extent.
The only benefit of using a cash account is that your maximum loss potential is your account balance. In a margin account, you can lose more money than your account balance.
The disadvantage of using a cash account is that it makes some assets like gold, Amazon, and Berkshire Hathaway unaffordable.
Benefits of a margin account
There are a few benefits of using a margin account including:
Buying power
The biggest benefit of having a margin account is that it increases your buying power. For instance, it lets you buy assets that are unaffordable in a cash account.
For example, if you have $1,000 in a cash account and a stock is trading at $10, the maximum number of shares you can buy is 100. On the other hand, if your account has 1:10, you can buy 1,000 shares.
Going long and short
Most margin accounts let you buy assets you expect will rise or short those you believe will drop.
For example, if you believe that a stock trading at $10 will drop to $5, you can short it and make a profit as it slips. Shorting works by borrowing shares, selling them, and buying them again when the price drops.
Flexibility
The other benefit is that a margin account is more flexible because it lets you trade more assets. It does that by giving you more buying power to allocate to your account.
Risks of margin accounts
Negative balance
As mentioned, since you are using borrowed funds, it is possible for you to lose more money than it is in your account balance. While this is possible, many brokers have introduced a negative balance protection.
Related » How to Not Blow Up a Trading Account
High risk
Margin accounts are extremely risky, especially when things go against you. A good example of this is Archegos Capital, a home office that lost over $20 billion in a few days as its investments went south.
Margin calls
A margin call is one of the most feared situations in the market. It refers to a situation where a broker asks a trader to add more funds to their accounts to maintain their margin.
If a trader fails to add funds to the account, the broker can go ahead and close the trade, often at a big loss.
Interest costs
Finally, there are usually some interest costs since a margin is usually a loan that a broker provides to you. At times, the interest of these loans can be substantially high.
How to manage margin accounts risks
There are several things that you need to do to manage your margin account well. First, always start with a small margin and then increase it as you gain more experience. For example, you can start with a 1:2 account followed by a 1:5 account and so on.
Second, never trade blindly since that will expose you to making some losses. In other words, always have a strategy. If you are a new trader, create, backtest, and forward-test a strategy well.
Third, always have a stop-loss for all your trades. A stop-loss will automatically stop your trade when it makes the maximum loss. Further, never leave your trades open overnight because of the pre-market gaps that happen often.
There are other margin account risk management strategies to consider, including not overtrading, trading what you know, and always having a trading journal.
Margin accounts and PDT
Another thing to keep in mind, especially in the United States, is known as pattern day trader (PDT) rules.
A PDT is a trader who executes four or more day trades within five days. And these trades should represent more than 6% of the customer’s total trades in the margin.
When you pass this threshold, the broker can pause your trading or ask for more information.
