Cash vs Margin Brokerage Accounts
Understanding the Types of Brokerage Accounts You Can Open
When you open a brokerage account, the broker will ask if you want to open a cash account or a margin account. Major differences, both positive and negative, exist between the two account types. Choosing the account type that works best for your trading style and needs is an important decision that could have significant ramifications for you financially, depending on how you manage your investing capital.
Cash accounts represent the most conservative choice and do not permit any borrowing of money (trading on margin) from the broker or financial institution. You must pay for any trades, in cash, by the required settlement date. This can restrict your ability to place trades more often as you may not have enough available cash settled and ready to deploy within your account at the moment you want to place your next buy order.
Likewise, you will need to wait until trade settlement to make a withdrawal of cash raised from a sell order. Stocks held in a cash account are not lent out by the brokerage to short sellers.
With no margin debt, investors holding securities within a cash account will never be subject to a margin call within their account. Investors also avoid the risk of losing their assets due to rehypothecation exposure, where their broker uses the investor's shares as collateral for the broker's loans from third parties. Additionally, if an investor uses only a cash account, she does not have the ability to short any stocks.
With a cash account, you must behave much more conservatively when dealing with options. For example, any calls you write must be fully covered and any puts you write must be fully secured by cash reserves in the event of exercise.
Invest Using Margin
Margin accounts allow the convenience of borrowing money from your broker to make additional investments, either to leverage returns, for cash flow convenience while waiting for trades to settle, or for creating a de facto line of credit for your working capital needs.
Without your knowledge, securities you hold in your margin account can be lent out to short sellers to generate additional income for the broker. Under certain circumstances, if this happens and the short sellers cover the dividend payment you are entitled to receive, you will not be allowed to claim the dividend as a qualified dividend subject to much lower tax rates, and you must instead pay ordinary personal taxes on the dividend income.
This could result in you paying practically double the tax rate you otherwise would have paid because your broker was trying to earn more profit for its own income statement at your expense. Additionally, you may be subject to rehypothecation risk.
Trade Settlement Requirements
Understanding how a brokerage settles trades, and potential issues that could affect you, can make the difference in your decision to use a margin account or stick with a cash account.
When trading stocks, bonds, options, or Treasury securities, the so-called regular-way trade settlement process requires you to deliver the cash if you are buying, or asset if you are selling, by the end of a certain number of days following the trade date itself. A brokerage often expresses this as "T + [insert the number of days here].
According to the Securities and Exchange Commission (SEC), for many years the typical settlement schedule was T + 5. About a decade ago, though, the current trade settlement requirements for cash accounts were changed, as follows:
According to FINRA, "The Federal Reserve Board's Regulation T and SEC Rule 15c3-3 provide for the possibility of extensions of credit by broker-dealers to investors when they have not promptly paid for a securities transaction." This makes it possible to extend the trade settlement an additional two days, for an effective T + 5.
Potential Trading Sanctions
Specifically, Regulation T states that if the investor's shortfall exceeds $1,000 in value, the broker must make a choice to either liquidate the investor's position or apply for an exemption from the regulators.
SEC Rule 15c3-3 states that if a long-held security (read: one not sold short) has not been delivered within 10 business days following settlement, the broker must buy replacement securities for the customer or apply for an exemption from the regulators.
Due to the fact that your broker is responsible for settling trades even if you don't come up with the required cash or securities, it has the right to penalize you with fees, as well as take other remedial measures to protect its own interest if you fail to honor your financial commitments.
Imagine that you entered a buy order for shares of common stock but didn't come up with the cash to pay for them when the trade went to settlement. The broker would have to make it up out of its own pocket, then sell the shares to recover its funds.
If the stock price declined in the meantime, it could go after you for the amount it lost on the transaction as a result of the movement in market value. This could expose you to substantial losses.
If you repeatedly fail to settle trades within your cash account, your broker can close your account and ban you from doing business with the firm. Additionally, if you trade too rapidly to the point you are buying shares with the float generated from the settlement process, you can be slapped with a so-called Regulation T violation, which will result in your account being frozen for 90 days.