Cash Account vs. Financial Options Account: What’s the Difference?
If you’re left a bit baffled by the differences between brokerage accounts, never fear: Here’s a quick rundown of what they are and what they do.
Cash account – This type of account asks you to deposit cash, and then you can use that cash to buy stocks, bonds, mutual funds, or other investments. It’s not much more complicated than that.
Margin account – In a margin account, the cash and securities in your account act as collateral for a line of credit that you take out from the brokerage in order to buy more stock. The interest rates that brokers charge are lower than typical credit card rates, but they do mean you’ll need to earn a much higher return on your investments than you would if you were only investing with your own cash. We generally counsel against using margin, but that doesn’t mean that getting a margin account is automatically a bad idea.
Financial Option account – This type of account allows you to trade up to 4 times as much stocks than a cash account without the limitations of a margin account! With a financial options account, RCI allows clients to finance up to 90% of the amount of stocks they wish to purchase, so if you want to buy $50,000 of Google stocks, but you don’t have the money to buy them and the prices are rising every minute, so you open a financial options account! With a financial options account you would only have to put up $5,000 in order to purchase the 50K worth of stocks! Now should the stocks go up 10% and you would like to cash them out, you now receive back $10,000 minus the interest rates!
Now should the stocks drop, Rainbow Century Investments (RCI) requires a maintenance of 20% of the total value of the stocks. The client will receive a margin call to either add in the missing amount or to sell the stocks and the client receives the difference. In order to protect our clients interests, RCI has a standing sell order, should the stocks drop 20%, they are sold off automatically in order to insure that you will not lose all your money, it’s a safety measure that is implied by RCI.
What is Leverage?
Most amateur traders (buy and hold traders, etc.) trade using cash, meaning that if they want to buy $10,000 worth of stock, they must have $10,000 in cash in their trading account. Professional traders, brokerage firms and even banks trade using leverage, meaning that if they want to buy $10,000 worth of stock, they only need $3,000 (approximately) in cash in their trading account (i.e. they only need a small percentage of the amount that they want to trade).
Trading using leverage is trading on credit, by depositing a small amount of cash, and then borrowing a larger amount of cash. For example, a trade on the EUR futures market has a contract value of $125,000 (i.e. the minimum amount that can be traded is $125,000), but using leverage, the same trade can be made with only $6,000 (approximately) in cash.
Leverage is related to margin, in that margin is the minimum amount of cash that you must have in order to be allowed to trade using leverage. In the above example, the $6,000 is the margin requirement that is set by the exchange for the EUR futures market, and the remaining $119,000 ($125,000 – $6,000) is the leveraged amount. RCI offers our clients the potential to increase their earnings by 4 times the amounts by utilizing Financial Options!
Non traders (and many amateur traders) believe that trading using leverage is dangerous, and is a quick way to lose more money than they started with. This is primarily because of the various warnings that are given regarding trading using leverage.
Leverage warnings are given by financial agencies (such as the US SEC), and by brokerages that offer trading using leverage, and usually use wording similar to the following:
Trading using leverage carries a high degree of risk to your capital, and it is possible to lose more than your initial investment. Only speculate with money you can afford to lose. With warnings like this, it is no wonder that many people consider trading using leverage to be dangerous. However, as is usual with government warnings, this is only half of the story, and very little of the truth.
Leverage is an Efficient Use of Capital
The reality is that professional traders trade using leverage every day because it is an efficient use of their capital. There are many advantages to trading using leverage, but there are no disadvantages whatsoever. Trading using leverage allows traders to trade markets that would otherwise be unavailable. Leverage also allows traders to trade more contracts (or shares, or forex lots, etc.) than they would otherwise be able to afford. However, the one thing that trading using leverage does not do, is increase the risk of a trade. There is no more risk when trading using leverage, than there is when trading using cash.
Financial leverage is important because it allows a company to maximize the profits earned by shareholders as compared to profits earned from equity operations. Companies that demonstrate the ability to manage leverage by repaying debts on time increase their chances of getting loans at better interest rates.
Understanding the Importance of Leverage
Understanding financial markets requires at least some understanding of leverage, the act of making trades that multiply potential returns for your assets. Leverage typically involves borrowing money to maximize returns. Leveraging is a viable strategy for the individual investor, whose appetite for risk in investing their retirement nest egg or kids’ college fund is, understandably, pretty low. However, for companies that regularly deal with various forms of risk, and can secure rates for loans no individual could ever dream of, leverage is an essential tool for maximizing returns.