Margin vs. cash account question arises when you try to open an investment account at your brokerage company. I did not give much thought to this election when I opened my investment account at Interactive Brokers. Hence I conservatively preferred a cash account. However, depending on your investment style, choosing the right account type is essential. Otherwise, you will probably face problems. I will explain the differences between margin and cash accounts in this post.
Cash account
Let’s start with the cash account to analyze the margin vs. cash account comparison. In this account type, you can only buy financial assets with the cash in your account. Besides, you cannot make short selling. In fact, you cannot make sales (margin selling) by borrowing from your brokerage house. However, if the brokerage house allows, you can rent your shares. Your risk is less because you don’t use debt. To clarify, the institutions that regulate the capital markets (such as SEC and FINRA) determine the rules regarding account types in the USA. Also, you have to follow some rules in trading. So what are these rules?
Trade day and settlement day
First of all, the date on which you place a share purchase order in cash accounts is called the trade day. The date when the asset you bought is transferred from the seller’s account to your account is defined as the settlement date. It’s usually 2 business days between these two. Hence, this rule is called T+2.
Cash liquidity violation
Let’s say you order to buy ABC shares but have no cash. You tried to obtain the money to meet this order by selling another asset the next day. However, the cash from the sale will be credited to your account after 2 business days due to the T+2 rule. Whereas the settlement date of your buy order is one day before the settlement date of your sell order. In other words, the cash to meet the requirements of this order is not available on the settlement date of the purchase order… This situation is called a cash liquidation violation.
Good faith violation
Let’s say you place a buy order for another ABC stock and have no cash. This time you have already sold assets for money on the settlement date of this purchase. However, you quickly resold the ABC stock on the trading date you placed the buy order without waiting for the settlement date. This behavior is called a good faith violation.
Free riding violation
Let’s say you finally sell the same stock you bought with no cash, let’s say one day later (before the settlement date). This behavior is called a free-riding violation.
Margin account
A margin account is a type of account that allows the investor to make transactions by borrowing and short selling at the brokerage house. Thus, the investor has the opportunity to earn more returns (or losses) in bull and bear markets by using leverage (debt). You can also withdraw cash from this account by showing your assets as collateral. This feature can also work as a short-term debt instrument for the investor. However, the brokerage house will charge you daily interest when you use a loan. This amount can be significantly higher than market interest rates.
An essential plus of the margin account is that the settlement in trades is instantaneous. So the T+2 rule is not valid. This feature may be a more suitable option for traders who trade frequently. It is also helpful to emphasize the minimum existence requirement. According to US regulations, those who open such accounts at a US-based brokerage firm must meet a minimum asset requirement of at least $2,000. Brokerage firms can increase this amount even more.
Margin call
In margin accounts, investors are asked to maintain a certain margin ratio. If it falls below this rate, the brokerage house requests the account holder to increase their collateral within a certain period. In other words, the investor will fulfill this requirement by depositing additional money into the account or selling some of his existing assets. Otherwise, the brokerage house fulfills this requirement by selling the assets of the account holder. The leverage ratios of brokerage firms in the USA are usually between 2 to 1 or 4-to-1. For example, TD Ameritrade offers its clients 4-to-1 leverage. As far as I can tell, the rates provided by Interactive Brokers vary according to different products.
Also, suppose the account holder owes money to the brokerage firm (i.e., has taken a loan). In that case, the brokerage house may lease the assets in the account to other investors without notifying the account holder. The account holder is not given rental income from those assets in this case. Even if leased assets distribute dividends, payments to the account holder are not legally (U.S. law) dividends and may be subject to different tax provisions.
Intraday trade
Intraday trading is when you buy and sell an asset during the day. For instance, you are trading intraday when you buy a short-sold stock on the same day and close your position (round trip). This definition applies to almost all asset classes. If you do not sell the asset you bought on the same day, it is not counted as an intraday transaction.
Pattern day trader
Those who open margin accounts and trade constantly should pay attention to the rule of being an intraday trader. According to US legislation, traders making 4 or more intraday transactions within 5 consecutive days are pattern day traders. In other words, the investor gains this title if the total buy-sell transactions made with the margin account in 5 days exceed 6%. These traders’ accounts are tagged by their brokerage house and are subject to certain restrictions.
For example, investors designated as pattern day traders must hold at least $25,000 in assets (cash or shares) in their margin trading account. A pattern day trader who fails to meet this minimum asset requirement may have his account frozen for 90 days. He may only be allowed to close his open positions during this time. They can be prevented from using credit. Similarly, suppose an intraday trader who receives a margin call does not complete the missing margin within 5 days. In that case, his account will be frozen for 90 days or until the margin is achieved.
These legal arrangements have been made to protect investors by deterring them from excessive trading.
Conclusion: margin vs. cash account
You should choose the account type by deciding on your investment strategy and how much risk you want to take. A cash account is less risky than a margin account. However, it is disadvantageous for traders who frequently trade due to the T+2 rule. On the other hand, you can get rid of the T+2 law with the margin account. However, this account type also has a minimum asset requirement and risk of being identified as a pattern day trader. I hope the information I gained from my research will be helpful to you. I invite my readers with experience in these matters to share their knowledge with us in the comments section. See you soon.