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Other than being able to borrow against one's portfolio value to purchase additional investments, how is a typical brokerage margin trading account different from a typical cash trading account?

Compared to a cash account, are there any additional features, restrictions, or interesting points to know about margin accounts?

  • Other than you can get into hot water a lot more quickly with a margin account? :) – mbhunter Jul 8 '11 at 3:54
  • @mbhunter Yes, other than that. That's the part I know already! :-) – Chris W. Rea Jul 8 '11 at 14:16
  • I am assuming you are not interested in legal obligations and SEC/FED regulations. If you are, let me know and I can post some examples. – Apoorv Khurasia Jul 10 '11 at 6:54
  • @MonsterTruck A pointer to such regulations might be handy. – Chris W. Rea Jul 10 '11 at 13:00
  • Margin accounts are subject to pattern day trader rules, cash accounts are not. Also, short sale is only allowed in margin accounts. – Victor123 Feb 14 '15 at 20:59
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Probably the most significant difference is the Damocles Sword hanging over your head, the Margin Call.

In a nutshell, the lender (your broker) is going to require you to have a certain amount of assets in your account relative to your outstanding loan balance. The minimum ratio of liquid funds in the account to the loan is regulated in the US at 50% for the initial margin and 25% for maintenance margins.

So here's where it gets sticky. If this ratio gets on the wrong side of the limits, the broker will force you to either add more assets/cash to your account t or immediately liquidate some of your holdings to remedy the situation. Assuming you don't have any/enough cash to fix the problem it can effectively force you to sell while your investments are in the tank and lock in a big loss. In fact, most margin agreements give the brokerage the right to sell your investments without your express consent in these situations. In this situation you might not even have the chance to pick which stock they sell.

Source: Investopedia article, "The Dreaded Margin Call"

Here's an example from the article:

Let's say you purchase $20,000 worth of securities by borrowing $10,000 from your brokerage and paying $10,000 yourself. If the market value of the securities drops to $15,000, the equity in your account falls to $5,000 ($15,000 - $10,000 = $5,000). Assuming a maintenance requirement of 25%, you must have $3,750 in equity in your account (25% of $15,000 = $3,750). Thus, you're fine in this situation as the $5,000 worth of equity in your account is greater than the maintenance margin of $3,750. But let's assume the maintenance requirement of your brokerage is 40% instead of 25%. In this case, your equity of $5,000 is less than the maintenance margin of $6,000 (40% of $15,000 = $6,000). As a result, the brokerage may issue you a margin call.

Read more: http://www.investopedia.com/university/margin/margin2.asp#ixzz1RUitwcYg

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  • With margin accounts you will be able to use the proceeds from a closed trade INSTANTLY. Without margin accounts this is the time you close the trade + 3 business days for clearing. In practice this means 4-5 days if there is a weekend or holiday involved between those 3 business days. This ties up your capital for an unfavorable amount of time, where as a margin account lets you continue to use the capital over and over again for more opportunities.

  • You CANNOT sell to open a position in cash accounts. This means no short selling. This means no covered calls or spreads and MANY other strategies.

These are the real differences you'll notice in a margin account vs a cash account.

Then there are the myriad of regulations that dictate how much cash you should keep in your account for any margin position.

  • Can you elaborate on 'no covered calls' in cash account? If I own the underlying stock, I can sell a covered call in a cash account. Is this not so? – Victor123 Jan 26 '14 at 16:51
  • Define "use the proceeds". The proceeds of a sale in a cash account are immediately available for purchases in that account. They won't be available for withdrawal until settlement day, however. – QuantumMechanic Mar 23 '14 at 23:52
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In summary:

  • Cash accounts do not allow short positions, except for covered calls or puts
  • Day-trading has different restrictions in the two account types
  • Proceeds from sales are available immediately in margin accounts
  • Margin will allow you to skate the delay between the start of and credit for a deposit
  • A margin account is like any other line of credit, and part of your credit report
  • Margin accounts can carry substantially more risk

In long form:

Spreads and shorts are not allowed in cash accounts, except for covered options. Brokers will allow clients to roll option positions in a single transaction, which look like spreads, but these are not actually "sell to open" transactions. "Sell to open" is forbidden in cash accounts. Short positions from closing the long half of a covered trade are verboten.

Day-trading is allowed in both margin and cash accounts. However, "pattern day-trading" only applies to margin accounts, and requires a minimum account balance of $25,000. Cash accounts are free to buy and sell the same security on the same day over and over, provided that there is sufficient buying power to pay for opening a new position. Since proceeds are held for both stock and option sales in a cash account, that means buying power available at the start of the day will drop with each purchase and not rise again until settlement.

Unsettled funds are available immediately within margin accounts, without restriction. In cash accounts, using unsettled funds to purchase securities will require you to hold the new position until funds settle -- otherwise your account will be blocked for "free-riding".

Legally, you can buy securities in a cash account without available cash on deposit with the broker, but most brokers don't allow this, and some will aggressively liquidate any position that you are somehow able to enter for which you didn't have available cash already on deposit. In a margin account, margin can help gloss over the few days between purchase and deposit, allowing you to be somewhat more aggressive in investing funds.

A margin account will allow you to make an investment if you feel the opportunity is right before requiring you to deposit the funds. See a great opportunity? With sufficient margin, you can open the trade immediately and then run to the bank to deposit funds, rather than being stuck waiting for funds to be credited to your account.

Margin accounts might show up on your credit report.

The possibility of losing more than you invested, having positions liquidated when you least expect it, your broker doing possibly stupid things in order to close out an over-margined account, and other consequences are all very serious risks of margin accounts. Although you mentioned awareness of this issue, any answer is not complete with mentioning those risks.

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Two more esoteric differences, related to the same cause...

When you have an outstanding debit balance in a margin the broker may lend out your securities to short sellers. (They may well be able to lend them out even if there's no debit balance -- check your account agreement and relevant regulations). You'll never know this (there's no indication in your account of it) unless you ask, and maybe not even then.

If the securities pay out dividends while lent out, you don't get the dividends (directly). The dividends go to the person who bought them from the short-seller. The short-seller has to pay the dividend amount to his broker who pays them to your broker who pays them to you. If the dividends that were paid out by the security were qualified dividends (15% max rate) the qualified-ness goes to the person who bought the security from the short-seller. What you received weren't dividends at all, but a payment-in-lieu of dividends and qualified dividend treatment isn't available for them.

Some (many? all?) brokers will pay you a gross-up payment to compensate you for the extra tax you had to pay due to your qualified dividends on that security not actually being qualified.

A similar thing happens if there's a shareholder vote. If the stock was lent out on the record date to establish voting eligibility, the person eligible to vote is the person who bought them from the short-seller, not you. So if for some reason you really want/need to vote in a shareholder vote, call your broker and ask them to journal the shares in question over to the cash side of your account before the record date for determining voting eligibility.

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