investing guide

Margin Account

margin account

A margin account can be looked at in a couple of ways. It can be looked at as extra money to invest, or as a way to avoid the issue of free-riding in a cash account.

Simply put a margin account is set-up by a broker basically saying they will lend you a certain amount of cash, that you will pay interest on, to purchase stock with based on how much actual cash you have of your own in your account.

MY ADVICE IS DO NOT EVEN THINK ABOUT USING A MARGIN ACCOUNT TO BORROW MONEY AS A BEGINNER BECAUSE YOU WILL PROBABLY END UP DIGGING YOURSELF INTO A HOLE.

Again 101 investing stock tip - NEVER PUT MONEY IN THE STOCK MARKET YOU CAN NOT AFFORD TO LOSE.

However, with that being said you should actually open up a margin account as opposed to a cash account for one simple rule and that is free-riding.

Anytime you buy or sell a stock there is what is known as the 3 day settlement rule. So if you sold a stock today the proceeds of that stock technically are not really yours until 3 days have passed and the trade is settled. This is really the basic definition of the rule but it is the easiest way to explain it.

So in other words, if you sold a stock today, then immediately bought another stock today with those proceeds from your sale, then sold that stock the very next day as well, you just violated the free-riding rule if you are trading in a cash account; which is something you never want to do.

In essence you are trading with money that is not technically yours to trade with because the cash you are trading with isn't settled into your account.

What is the simplest way to avoid the free-riding rule?

Open a margin account and treat it as a cash account. In other words, you can move in and out of stocks without waiting for the 3 day settlement to occur.

NOTE - This does NOT mean you can day trade. Please read our day trading section to learn more.

Basically, the broker is covering you in a sense for 3 days, until your trade has settled, even though you aren't really using the brokers money. Just remember to only trade with the actual cash you put into the margin account to begin with NOT what the broker is willing to lend you.

If you do not plan on trading frequently then a simple cash account is just fine as well. Margin accounts simply give you much more flexibility and do not cost you anything extra.