Types of Brokerage Accounts

Opening an account at a brokerage firm is as easy as opening a bank account. The investor is required to provide basic personal information, such as occupation and social security number, as well as more specific information about his or her financial circumstances. Brokers are required to become familiar with their customers in order to be able to use their judgment with regard to sizable transactions and to whether or not credit should be issued to finance trades.

There are three types of brokerage accounts that can be used for buying and selling securities: cash accounts, margin accounts, and discretionary accounts. Using a cash account, the investor is required to pay the full price of the securities purchased on or before the transaction's settlement date. The settlement date is usually three business days after the order to buy or sell has been executed (the trade date). For government securities and options, the settlement date is generally the next business day after the trade date. The securities must also be delivered within three days to avoid any additional fees. After the settlement date, the proceeds of the sale – minus commissions – are either mailed or deposited into the seller's account with the brokerage firm (assuming the seller is also using a cash account).

A margin account allows the investor buy securities without having to pay the full cash price. The balance needed to complete the transaction is borrowed from the brokerage firm. The maximum amount that can borrowed depends upon the margin requirement set by the Federal Reserve Board. For example, with a margin requirement of 50 percent, an investor buying shares of stock worth $10,000 would have to pay at least $5000 in cash and borrow the remaining $5000 from the brokerage firm. The firm would use the purchased stock as collateral against the loan. These securities can also be loaned to other clients of the brokerage firm who may be executing short sales.

The brokerage firm charges interest on the amount borrowed by the margin investor. Risks are greater in margin trading because using borrowed funds to buy stocks could lead to substantially larger losses if the stocks were to drop in price. However, if the price of the stock goes up significantly, the rate of return is substantially greater for the margin investor because his or her money is leveraged.

If stock prices decline in a margin account, the brokerage firm will give the investor a margin call, which is a notice requesting that additional money be deposited in order to maintain the account's minimum margin requirement. If the required funds aren't put into the account, the firm can liquidate the securities, and the investor would still be liable for any losses incurred by the brokerage firm.

With a discretionary account, the investor agrees to allow the brokerage firm to decide which securities to buy and sell on the investor's behalf as well as the amount and price to be paid for the transactions. For the unethical broker, an arrangement such as this could be quite lucrative. The prudent investor should therefore closely monitor this account on a monthly basis in order to determine if any unnecessary or ill-advised activity has taken place. Unless the broker is known and implicitly trusted by the investor, discretionary accounts should be used with extreme caution.

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