Investors who would like to purchase securities can do using a brokerage account. They should keep in mind that, the two main types of brokerage accounts are cash accounts and margin accounts. Importantly, the major difference between those types of accounts is their respective monetary requirements.
Let’s start with the cash account. When it comes to a cash account, all transactions must be made with available cash or long positions. Moreover, when buying securities in a cash account, they must deposit cash to settle the trade or sell an existing position on the same trading day-so cash proceeds are available to settle the buy order.
If you give the brokerage firm permission, it is also possible to lend shares held in a cash to other interested parties. Interestingly, this can be a source of additional gain for an investor. The name of this process is share lending or securities lending.
Now, let’s discuss another option. Imagine that you have a cash account with securities that are in demand with sellers and hedge funds. So, if you have such an account you can let your broker know that you are willing to lend out your shares. In case there is a demand for these shares, your broker will provide you with a quote on what they would be willing to pay you for the ability to lend these shares.
Brokerage accounts and interesting details
As we mentioned earlier there are two main types of brokerage accounts. It makes sense to learn more about both of them. People should pay attention to even minor details, so let’s have a look at some interesting details regarding cash accounts.
So, if you accept the broker’s offer, your broker will lend your shares out to a short seller or hedge fund for a higher rate. For instance, your broker may give you an 8% interest on the loaned shares, while lending out a 13%. The method described above also allows you to keep your existing long position in the security as well as benefit from its upward movement.
Unsurprisingly, there can be a lot of demand by short-sellers and hedge funds to borrow securities. Especially when it comes to securities that are typically hard to borrow. As a reminder, when borrowing capital or securities, the borrower has to pay fees. The borrower will have to pay interest on the amount borrowed.
The exact amount of interest charged for borrowing securities will vary, depending on two factors. Market rates and the demand for the securities. As a reminder, the most attractive securities to lend are those that are the hardest to borrow for short selling.
We already discussed the first main type, now we can move to a margin account. It allows investors to borrow against the value of the assets in the account to purchase new positions or sell short.
Interestingly, they can use margin to leverage their positions and profit from both bullish and bearish moves in the markets. It is also possible to use margin to make cash withdrawals against the value of the account in the form of a short-term loan.
For people looking to leverage their leverages, a margin account can be very useful and cost-effective. You should keep into account that, when a margin balance (debit) is created, the outstanding balance is subject to a daily interest rate charged by the firm. The current prime rate plus an additional amount charged by the firm determines these rates. Moreover, these rates can be quite high.
We can discuss one example of a margin account. For instance, an investor with a margin account may take a short position in XYZ stock if they believe the price is likely to fall. If the price does fall, investors can cover their short position at that time. All they have to do is to take a long position in XYZ stock. Thus, investors earn a profit on the difference between the amount received at the initial short sale transaction and the amount they paid to buy shares at the lower price.
It is worth noting that, margin accounts must maintain a certain margin at all times. People should not forget that if the account value falls below this limit, the client is issued a margin call. Some people may not be aware of its role, so let’s discuss a margin call. It is a demand for a deposit of more cash, securities to bring the account value back within the limits. Notably, customers can add new cash to their accounts or sell some of their holdings to raise the cash.
In this article, we discussed two main types of brokerage accounts. As stated earlier it is desirable to have at least some knowledge about both types. So, let’s learn even more about a margin account.
When it comes to a margin account, the securities in this account may be lent out to another party. The brokerage firm can also use securities as collateral, at any time without notice or compensation to the investor. But that scenario is only possible if they hold a debt balance (or a negative balance) on the account.
Notably, the borrowers of stocks held in margin accounts are generally active traders, such as hedge funds. Active traders are typically either trying to short a stock or need to cover a stock loan that has been called in. Investment firms might borrow stocks from a brokerage firm. We are talking about firms that need an underlying instrument for a derivatives contract. Moreover, the brokerage firm may also pledge the securities as loan collateral.
Interestingly, if an investor’s margined shares pay a dividend but are lent out, you don’t actually receive real dividends because you aren’t the official holder. Nonetheless, you receive “payments in lieu of dividends” which may carry different tax implications.