When starting out their investment journey, many investors has this question ,”What are Margin Accounts?”
To invest in stocks for passive income in Singapore, all investors has to open a brokerage account and learn how to buy stocks in Singapore, they are usually made available the option to use both the Cash Account and Margin Account? However, what is the difference between them and how are they useful to the investor?
What are Cash Account?
As the name speaks, the cash account is an account that you execute trades using cash. In order to execute a trade, you would have first to fund your account with cash and your trade size is limited to the amount of cash that you have in account.
Peter has funded $10,000 into his account, he wants to buy 100 shares of The Electric Car Inc. which is currently trading at $100.
Total Cost of Trade = $100 x 100 shares
Peter would be able to execute this trade as he has $10,000 in his account. Peter would not be able to buy 1 more share as he does not have the extra $100 in his cash account. He would have to top up more money before buying more.
Do take note that this example does not include Commission, Clearing Fee and Custody Fees. Upon inclusion of those charges, Peter will have insufficient money to execute the trade.
One advantage of using Cash accounts to execute trades is that the commission is usually lower which makes it my preferred method of trading.
What are Margin Accounts?
The margin account is an account that allows you to utilize leverage to increase your trading power. A margin account allows you to borrow money from your brokerage house to execute trades, thereby, allowing you to increase your investment returns with a limited capital.
Peter has funded $10,000 into his account. However, his brokerage allows him to leverage an extra 100%, which gives him an additional $10,000 to trade with.
In total, Peter will be able to buy 200 shares of The Electric Car Inc.
Let’s say that the share price appreciates to $120 and Peter sold them away.
|Initial Capital – $10,000
No. Of shares – 100
Sales – 100 x $120 = $12,000
Profit – $12,000 – $10,000 = $2,000
Return on Investment – $2,000/$10,000 = 20%
|Initial Capital – $10,000
Amount borrowed – $10,000
No. Of shares – 200
Sales – 200 x $120 = $24,000
Profit – $24,000 – $20,000 = $4,000
Return on Investment – $4,000/$10,000 = 40%
We can see from the example that with the margin function, Peter is able to achieve higher returns on his investments using borrowed cash, which allows him to grow his portfolio faster.
The borrowed cash would have to be returned with interest. Even with the interest payments, Peter’s returns on investment would still be higher.
As the Chinese proverb says, “Water can float a ship and sink a ship”. The margin account is a tool that can float you and sink you. If the stock price goes down, and the overall portfolio value of Peter’s value goes below the allocated value by the brokerage house, Peter will face a margin call.
When Peter receive a Margin Call from his brokerage house, he would have to top up his account with extra cash. If the stock price continues to go down, he would have to top up with more cash.
If Peter does not top up the required amount of cash by a certain time as dictated by the brokerage house, the brokerage house has the right to sell off his stock holdings at current market value.
Therefore, there is no such thing as buy and hold during a margin call. Peter’s portfolio will be liquidated at a loss to repay the money he borrows. When I say portfolio, it means that the brokerage house will sell away Peter’s other stock positions if selling off his position in The Electric Car Inc. is not sufficient to cover the amount he borrows.
If liquidating the whole portfolio is insufficient to cover the amount he owe, Peter would owe the remaining amount including interest to the brokerage house. And here is where the horror story begins.
Well-meaning friends and relatives would always advice one to not touch the stock market as they have known of people who got into huge debt through the stock market.
This is a myth.
The stock market do not throw people into debt. I have never known anyone that got into debt because of the stock market. The act of borrowing to buy stocks, utilizing monies that you don’t have, monies that you cannot repay gets you into debt.
The same principle applies to leveraging to fund your monthly extravagance.
In conclusion, we can see that having margin facility will allow you to utilize more cash in your investment to grow your portfolio faster. However, convenient it may be, it is a double edged sword that has taken the fortune and lives (literally) of many. Personally I stick to my cash account as I invest only with monies that I have. Besides that, I get a lower commission rate as well.
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