Your broker will ask you whether you want a cash account or a margin account when you open a brokerage account. There are some major differences between the two account types, which present unique opportunities. The biggest difference is that margin accounts allow people to borrow money to invest or trade.
Choosing the account that works best for your trading style and needs is an important decision. It could have significant financial impacts.
Learn what to consider when choosing between margin accounts and cash accounts.
What's the Difference Between Margin and Cash Accounts?
|Margin Account||Cash Account|
|Buying Power||May borrow money to trade and invest||Limited to cash deposits|
|Trading Strategies||Long, short, naked options, etc.||Only long and covered options|
|Securities in Your Account||May be lent out by your brokerage||Will remain in your possession|
Cash accounts are the most conservative choice. They don't permit borrowing money from the broker or the financial institution to buy stock. There's no "trading on margin"—buying (or selling) a security without having the cash (or security being sold) required for the transaction. You must pay for any trades in cash with this type of account, and you must do so by the required settlement date.
This can effectively reduce your buying power and restrict your ability to place trades as often as you might like. Depending on how frequently you trade and the settlement dates on those trades, you might not have enough settled cash at the moment you want to place your next buy order.
You'll also have to wait until trade settlement to make a withdrawal of the cash you raised from a sell order.
Margin accounts offer the convenience of borrowing money from your broker to make additional investments. Not only can you use cash before your previous sell order settles, but you can also borrow money beyond your total funds—like a loan from your brokerage.
This extra buying power can help leverage returns, provide cash flow convenience while waiting for trades to settle, or create a de facto line of credit for your working capital needs. Your account effectively serves as collateral.
The flip side of the reduced buying power of cash accounts is a lower risk level. By avoiding debt, it's easier to prevent significant losses. Cash accounts are the more conservative choice for investors and traders.
Investors holding securities within a cash account will never be subject to a margin call within their account. That's because there's no margin debt. Investors also avoid the risk of losing their assets due to rehypothecation exposure. This is when their broker uses the investor's shares as collateral for the broker's loans from third parties.
Those using a margin account accept greater levels of risk in exchange for greater opportunities. This is especially true when someone uses as much margin as they're allowed to use. By using debt, you expose yourself to the potential for losses greater than your initial investment.
Investing using margin is risky. This option isn't necessary for most investors.
However, someone using a margin account isn't required to borrow money, so having a margin account doesn't necessarily add risk to your investments, it simply allows you to take more risks with your funds.
With increasing buying power, a more aggressive risk tolerance, and greater flexibility with settlement dates, margin accounts offer access to more trading strategies than a cash account.
An investor isn't able to short any stocks if they use only a cash account, for example. They must behave much more conservatively when dealing with options when in a cash account. Any calls that are written must be fully covered; any puts you write must be fully secured by cash reserves in the event of exercise.
While brokerages will determine what an investor is allowed to do on an individual basis, margin accounts are generally more flexible when it comes to strategies. An investor is more likely to be able to use advanced strategies like writing naked options and shorting stocks.
Securities in Your Account
Stocks held in a cash account aren't lent out by the brokerage to short sellers. Short sellers are those who borrow shares from a broker to sell.
Securities you hold in your margin account can be lent out to short sellers to generate additional income for the broker. This can happen without your knowledge.
For the most part, you won't notice when the brokerage has lent out your securities, but there is a quirk when it comes to dividends. You might not be able to claim a dividend payment as a "qualified" dividend (which comes with lower tax rates) if short sellers cover the dividend payment you are entitled to receive. However, some brokerages offer credits to help compensate investors for the increased tax burden.
Which Is Right for You?
In general, novice traders and investors should stick with a cash account, while those with more experience may consider taking advantage of margin trading.
When a Margin Account Works Best
A margin account works best for experienced traders and investors who know how to manage risk. These individuals should have an intimate understanding of how trades execute, how to study charts, how to assess business fundamentals, and all of the basic skills that go into investing. Without these skills, it would be easy to make a costly mistake before you even realize anything has gone wrong.
When a Cash Account Works Best
Most investors should be perfectly fine with a cash account, particularly those who are just starting. There are risks associated with a cash account, and you can lose your principal, but the transactions in a cash account are more straightforward, which makes it easier for beginners to control their risks.
How Trade Settlement Works
It's important to understand how trade settlements work to better understand the difference between margin and cash accounts.
The "regular way" trade-settlement process requires that you deliver the cash if you're buying, or the asset if you're selling. This must be done by the end of a certain number of days after the trade date itself when you're trading stocks, bonds, options, or Treasury securities.
Your brokerage expresses the settlement time as "T + [insert the number of days here]." In this case, "T" is the date the trade executes.
In 2017, the Securities and Exchange Commission (SEC) announced a new standard that requires all trades to settle in T + 2, if not sooner.
Potential Trading Sanctions
Regulation T states that if the investor's shortfall exceeds $1,000 in value, the broker must either liquidate the investor's position or apply for an exemption from the regulators.
Your broker is responsible for settling trades even if you don't come up with the required cash or securities, so it has the right to hit you with fees.
Your broker could close your account and ban you from doing business with the firm if you repeatedly fail to settle trades within your cash account. If you trade too rapidly, to the point where you're buying shares with the float generated from the settlement process, you can be slapped with a Regulation T violation that freezes your account for 90 days.
The Bottom Line
While the vast majority of beginner traders and investors will be best served by a cash account, margin accounts do have their advantages. By not needing to have cash on hand to cover every trade, margin accounts increase buying power and potentially leverage returns—but these advantages come with enhanced risk. After using a cash account for a while, individuals may decide that they are responsible enough with investments to add margin to their account.
- Cash accounts are the more conservative choice; they don't let you borrow money from the broker or the financial institution to buy stock.
- Margin accounts allow you to borrow money from your broker to trade or invest, which could potentially leverage your returns, but it comes with extra risks.
- The common trade-settlement process requires you to deliver the cash (if you're buying) or asset (if you're selling) within a certain time frame after the trade date.
Office of Investor Education and Advocacy. "Types of Brokerage Accounts."
Securities and Exchange Commission. "Investor Bulletin: Understanding Margin Accounts."
Board of Governors of the Federal Reserve System. "The Ins and Outs of Collateral Re-Use."
Securities and Exchange Commission. "Margin: Borrowing Money to Pay for Stocks."
Internal Revenue Service. "Topic No. 404 Dividends."
Fidelity. "Annual Credit for Substitute Payments."
Securities and Exchange Commission. "Updated Investor Bulletin: New 'T+2' Settlement Cycle – What Investors Need to Know."
Government Publishing Office. “12 CFR 220.4 - Margin Account,” Page 11.
Securities and Exchange Commission. “Freeriding.”