Hello! Welcome to your second lesson in the "Setting Up Your Investment Hub" module.
In our last lesson, we covered the essential features to look for when choosing a brokerage firm. You learned to evaluate brokers based on fees, account types, and the tools they offer. Now, we're going to dive into one of the most important decisions you'll make when you open your account.
Today, we'll compare cash accounts and margin accounts, explaining the risks associated with margin. This is a critical distinction that affects your buying power, your potential returns, and most importantly, the level of risk you take on. Understanding this is fundamental, especially given your interest in both long-term investing and active trading.
Let's get started.
The Cash Account: Your Foundation
A cash account is the most straightforward type of brokerage account. The rule is simple: you can only buy and sell securities using the money you have deposited in the account.
Margin account vs. cash account
To start, let's get a clear definition from the Wealthsimple article 'Margin account vs. cash account'.
Please read the section 'What is a cash account?'. It provides a concise explanation of what you can and cannot do with this account type.
As you just read, with a cash account:
- You pay for all your investments in full with your available cash.
- Your potential loss is limited to the total amount you have invested. If you invest $1,000 and the company goes bankrupt, you can lose your $1,000, but no more.
- You cannot engage in certain advanced strategies like short selling (betting that a stock's price will go down).
A cash account is the default for most new investors because its simplicity makes it a safer starting point.
A Note on Settled Funds
One practical aspect of cash accounts involves "settlement." When you sell a stock, the cash from that sale isn't officially in your account and available for withdrawal for one business day (this is called T+1 settlement). While most brokers let you immediately reinvest that money, you can't sell the new investment until the funds from the original sale have settled. Doing so is a violation called "free riding" and can get your account restricted. This is a key reason why active day traders often use margin accounts, which we'll discuss next.
The Margin Account: Investing with Borrowed Money
A margin account allows you to do something a cash account doesn't: borrow money from your brokerage firm to buy more investments than you could with your own cash. This practice is called using leverage or buying on margin.
Margin account vs. cash account
Let's turn back to the Wealthsimple article for a definition of a margin account.
Now, read the section 'What is a margin account?'. Focus on how it differs from a cash account, specifically the concepts of borrowing, collateral, and interest.
In a margin account, your broker gives you a line of credit. The cash and securities you hold in the account act as collateral for this loan. When you use margin, you have to pay interest on the borrowed amount.
This might sound appealing—more money means more potential profit, right? But it's a double-edged sword.
The Power and Peril of Leverage
Leverage amplifies everything. When your investments go up, your profits are magnified. When they go down, your losses are also magnified. This is the single most important concept to understand about margin.
The following video does an excellent job of illustrating this with simple, clear drawings.
Margin Account Or Cash Account? [Which Is Better?]
The video 'Margin Account Or Cash Account?' from Mind Over Finance provides a brilliant visual explanation of how leverage impacts your returns—for better and for worse.
Please watch two key segments: First, from 02:40 to 05:57, see how a margin account can amplify your profits compared to a cash account. Then, watch from 05:57 to 08:34 to see how it can dramatically amplify your losses. Pay close attention to the return on investment (ROI) calculations in both scenarios.
As the video demonstrated, if you invest $500 of your own money and borrow $500 on margin, your gains and losses are calculated on the full $1,000 position, but your personal capital at risk behaves very differently.
The Ultimate Risk: The Margin Call
The danger of margin isn't just about amplified percentage losses. It's about a specific event called a margin call.
A margin call is a demand from your broker to add more money to your account or sell some of your assets to bring your account back up to a minimum required value (the "maintenance margin"). This happens when the value of your investments drops too far, reducing the value of the collateral you've put up for the loan.
If you cannot meet the margin call, the brokerage has the right to sell your securities—without your consent—to pay back the loan. This can force you to lock in losses at the worst possible time, preventing you from waiting for a potential recovery in the stock price.
This is the critical difference:
- In a cash account, if a stock you own drops, you can hold it and wait, even if it goes to zero. The decision is yours.
- In a margin account, if a stock you own drops enough, the decision may be taken out of your hands, and your position sold for you at a loss.
Test your understanding!
You have $10,000 to invest in a stock that costs $100 per share.
- Cash Account: You buy 100 shares ($10,000 / $100).
- Margin Account: You use your $10,000 and borrow an additional $10,000 from your broker to buy a total of 200 shares.
Question 1: The stock price rises to $120 per share. What is your profit in dollars and your Return on Investment (ROI) in both scenarios? (Ignore interest for simplicity).
Question 2: The stock price falls to $70 per share. What is your loss in dollars and your ROI? Why is the situation in the margin account particularly dangerous here?
Show answer
Scenario 1: Stock rises to $120 (+20%)
- Cash Account: Your 100 shares are now worth $12,000. Your profit is $2,000. Your ROI is ($2,000 profit / $10,000 invested) = 20%.
- Margin Account: Your 200 shares are now worth $24,000. After paying back the $10,000 loan, you have $14,000. Your profit is $4,000. Your ROI is ($4,000 profit / $10,000 of your own money invested) = 40%.
Leverage doubled your return.
Scenario 2: Stock falls to $70 (-30%)
- Cash Account: Your 100 shares are now worth $7,000. Your loss is $3,000. Your ROI is (-$3,000 loss / $10,000 invested) = -30%. You can choose to hold the shares and wait for a recovery.
- Margin Account: Your 200 shares are now worth $14,000. After accounting for the $10,000 you owe the broker, your account equity is only $4,000. Your loss is $6,000. Your ROI is (-$6,000 loss / $10,000 of your own money invested) = -60%.
The situation is dangerous because this significant drop in your account's equity could trigger a margin call, forcing you to sell at a $6,000 loss.
Leverage doubled your loss.
Cash vs. Margin: Which Is Right for You?
So, how do you choose? The decision comes down to your experience, strategy, and risk tolerance.
Margin account vs. cash account
The Wealthsimple article provides a helpful framework for making this choice.
Read the final section, 'What factors you should consider to determine which to open'. This will help you connect what you've learned to your own personal situation.
For a beginner, the answer is clear: start with a cash account. The risks associated with margin are significant and can wipe out a new investor's capital very quickly. Your primary goal at the beginning is to learn the process of investing and build good habits without taking on unnecessary risk.
As you gain experience and want to explore active trading strategies like day trading, you may consider applying for margin privileges. It is often necessary for day trading to meet certain regulatory requirements and to avoid cash settlement violations. However, it should be treated as a sharp tool for advanced users, not a way to get rich quick.
Conclusion
Today you've learned the fundamental difference between cash and margin accounts—a crucial piece of knowledge for any investor.
Here are the key takeaways:
- Cash accounts are simple and safe: you invest your own money, and your risk is limited to what you put in.
- Margin accounts allow you to use leverage (borrowed money) to increase your buying power.
- Leverage is a double-edged sword: It magnifies both your profits when you are right and your losses when you are wrong.
- The most significant risk of margin is the margin call, which can force you to sell your investments at a loss.
- For all new investors, starting with a cash account is the most prudent path.
Now that you understand brokerage features and these key account types, you're ready for the next practical step. In our next lesson, we will walk through the process of opening a brokerage account.