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
Three types of accounts are used for buying and selling
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.
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.
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.
|Proceeds from sale of 100 shares of JNJ at $65
|Cost of 100 shares plus commission
|Less interest expense
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.
|Proceeds from sale of 100 shares of JNJ at $50
|Cost of 100 shares plus commission
|Less interest expense
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.
Categories in Trading Mistakes
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Failure to control Risk
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Lack of Discipline
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