Types of Accounts at Brokerage Firms

Opening an account at a brokerage firm is as easy as opening a bank account. Many brokerage firms require little more than a deposit. You are asked to supply basic information, such as your occupation and Social Security number, in addition to more specific information about your financial circumstances. Brokers are required to get to know their customers, to be able to use judgment with regard to sizable transactions, and to determine whether customers can use credit to finance their trades.

Brokerage firms must ask their customers how securities are to be registered. If you decide to leave your stock certificates, for example, in the custody of your brokerage firm, the securities are registered in street name. Street name refers to the registration of investor- owned securities in the name of the brokerage firm. Accrued dividends of street-named securities are mailed to the brokerage firms, where they are then credited to customer accounts. The main disadvantage of registering stocks in street name is that the brokerage firms may not forward to you all the mailings of company reports and news. The advantage of holding securities in street name is that when securities are sold, the customer has no need to deliver the signed stock certificates within the three days required before the settlement of the transaction.

Securities that are registered in your name can be kept either in your broker’s vault or mailed to you. You should store these security certificates in a bank safe-deposit box because they are negotiable securities. If they are stolen, you might face losses.

Three types of accounts are used for buying and selling securities:
* Cash
* Margin
* Discretionary

Cash Account

Acash account with a brokerage firm requires that cash payments be made for the purchases of securities within three days of the transaction. With a cash account, you are required to pay in full for the purchase of securities on or before the settlement date. The settlement date is defined as three business days after an order is executed and the date on which the purchaser of the securities must pay cash to the brokerage firm and the seller of the securities must deliver the securities to the brokerage firm. If you buy stock on a Monday, for example, your payment is due on or before the Wednesday of that week, assuming that no public holidays take place during those three days. That Monday is referred to as the trade date (the date on which an order is executed). If you do not pay for the securities by the settlement date, the brokerage firm can liquidate them. In the event of a loss, the brokerage firm can require additional payments from you, to make up for the loss and to keep your account in good standing. For online accounts, the money generally needs to be in the account before the trade is made.

When stocks are sold, stock certificates must be delivered or sent to the brokerage firm (if securities are not held in street name) within three days to avoid any charges. After the settlement date, the proceeds of the sale, minus commissions, are either mailed to the investor or deposited into a cash account with the brokerage firm, depending on the arrangements made in advance. Determine whether any fees are charged for the management of cash in the account or for access to a money market account.

Margin Account

Amargin account with a brokerage firm allows a brokerage client to purchase securities on credit and to borrow securities to sell short. In other words, a margin account with a brokerage firm allows you to buy securities without having to pay the full cash price. The balance is borrowed from the brokerage firm. The maximum percentage of the purchase price that a client can borrow is determined by the margin requirement set by the Federal Reserve Board. Brokers can set more strict requirements for their clients. For example, with a margin requirement of 50 percent, if you are buying stock worth $12,000, you would have to put up at least $6,000 in cash and borrow the other $6,000 from the brokerage firm. If the margin requirement is 60 percent, you would have to put up at least $7,200 and borrow the balance. The brokerage firm uses the stock as collateral on the loan. These securities are held in street name and also can be loaned to other clients of the brokerage firm who are selling short.

The brokerage firm charges interest on the amount borrowed by the margin investor. Risks are magnified in margin trading because losses represent a greater portion of the money invested. However, if the price of the stock goes up, the rate of return is greater for the margin investor than for the cash investor because the margin investor has invested less money. In both cases the investor must pay interest on the margin loan, increasing a loss and slightly reducing a profit. This concept is illustrated in Table 7–4.

Table 7-4
Rate of Return Using a Cash Account versus a Margin Account
An investor buys 100 shares of Johnson & Johnson (JNJ) at $60 per share and sells at $65 per share. The margin requirement is 50 percent. Commissions per trade are $50. Interest on the margin account is $45.

	Cash Account	Margin Account
Proceeds from sale of 100 shares of JNJ at $65	$6,500	$6,500
Less commissions	(50)	(50)
Net proceeds	6,450	6,450
Cost of 100 shares plus commission	(6,050)	(6,050)
Gross profit	400	400
Less interest expense		45
Net profit	$400	$355

Rate of return = profit/invested funds
= 400/6,050 = 6.6% (cash account)
= 355/3,025* = 11.73% (margin account)
* Invested funds = $3,025 ($6,050 * 50%).

The proceeds and the gross profit are the same for both the cash and margin accounts. The differences are that the investor deposits the entire cost of the shares for the cash account ($6,050), whereas an investor in the margin account only puts up 50 percent ($3,025). The rate of return is greater for the margin investor because the amount invested is much less than that of the cash investor despite the lower net profit caused by the interest expense for the margin investor. Determine the rate of return if the data above are the same except for Johnson & Johnson stock being sold at $50 per share.

	Cash Account	Margin Account
Proceeds from sale of 100 shares of JNJ at $50	$5,000	$5,000
Less commissions	(50)	(50)
Net proceeds	4,950	4,950
Cost of 100 shares plus commission	(6,050)	(6,050)
Gross loss	(1,100)	(1,100)
Less interest expense		45
Net loss	(1,100)	(1,145)
Investment	$6,050	$3,025*

Rate of loss = -1,100/6,050 = -18.18% (cash account)
= -1,145/ 3,025 = -37.85.% (margin account)
* Margin requirement $3,025 ($6,050 * 50%).
The rate of loss is magnified with a margin account because the net loss is greater and the amount invested is less than the figures in the cash account.

If stock prices decline in a margin account, the amount owed to the brokerage firm becomes proportionately larger. In order to protect their positions, brokerage firms set maintenance margins, which are minimum equity positions investors must have in their margin accounts. When funds fall below the maintenance margin, the broker sends the investor a margin call. Amargin call is a notice requesting that the investor pay additional money to maintain the minimum margin requirement. If the investor does not deposit additional funds, the brokerage firm can liquidate the securities. The investor is then liable for any losses incurred by the brokerage firm. Two types of transactions can be performed with only a margin account: selling stocks short and writing uncovered stock options.

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