Investors must open a brokerage account to start investing in stocks. While opening a brokerage account, your broker will ask you to choose between a cash account and margin account.
There are important differences between a cash and margin account which investor needs to know before opening a brokerage account.
In a Margin Account, the broker lends money to buy securities. It allows you to buy stocks on credit which is also known as buying on Margin. With this facility investors will be able to buy more stocks than he would be able to buy normally.
Loan amount will be collateralized by the securities and cash available with the customer. If these accounts fall below a certain margin ratio as defined by the broker, investor will be issued a margin-call to deposit more cash.
This means, where stock price drops, buyer is required to deposit additional cash or sell certain securities to bring the account value back within the limits.
When investor sell securities from this type of account, the proceeds first go to the broker for repayment of loan until it’s fully paid.
For the loan amount, investor is also required to pay interest. Interest rates are often much lower than the traditional loan rates from banks and financial institutions. Generally, its used to buy securities for short term investments.
Buying power of a margin account is determined daily based on the price movement of the marginable securities held by the buyer
A 50% initial margin means, the broker is allowing you to buy stock worth twice of the cash available in your account. This means, if Rs 10, 000 has been deposited in your account then you can buy Rs 20, 000 worth of stocks (i.e. Rs. 10, 000 of margin and Rs 10, 000 of cash). When you sell the stock, you pay back Rs. 10000 loan plus interest to broker and keep the balance.
Buying in margin is a very high-risk strategy to get huge profit if executed properly.
Cash Account is very simple. In a cash account, account holder can trade using the money available in his own account. He cannot lend money from the broker. To buy security, investor must deposit cash to settle the trade.
Having a margin account with the broker is good for you as an investor as it allows you to buy more stocks than the money available in your account.
However, if market declines and your margin-stock send the ratio below the required minimum limit then your broker will issue a margin-call to deposit more cash as collateral. If you don’t deposit cash, the broker has power to sell sufficient amount of your margin-stocks to restore the minimum value-to-loan ratio.