Before you can begin trading stocks, you must open an account with your broker. Depending on what type of stockbroker you choose, opening an account can range from a very personal to very impersonal process.
There are several different types of accounts that most brokers offer in addition to the level of service you receive from the different types of brokers. First, let’s look at how the two basic different type of brokers set up accounts and then we’ll look at the different types of accounts.
Full-service Broker
A full-service broker will want to sit down with you and your spouse or partner and go over your financial situation in some detail. He or she will want to know about any debts, cash in the bank, any stock or mutual funds you own, retirement plans, insurance, home ownership, kids, and so forth.
It’s not that they are nosey – they are required to gather this information before they can make recommendations to you regarding investments. In the business, it’s called, “know your customer.” If a broker makes an inappropriate investment recommendation to someone because he or she did not take the time to find out all about the customer’s financial circumstances, the broker can face severe penalties.
This is one of the services you buy with the commissions you pay a full-service broker – recommendations that are appropriate for you individual financial situation. Many investors consider it money well spent.
Discount/Online Brokers
Discount and online brokers offer no advice and make no recommendations; therefore, setting up accounts with them is far less personal. There are still forms to fill out and questions to answer, however no one is going to come to your house and look at your checkbook.
You are on your own in determining if stock is right for you. Some particular types of investment (options, futures, and other high-risk investments) require you to certify that you are a knowledgeable investor, able to understand the risks associated with the product.
Account Types
There are several types of accounts that most brokers offer. They include:
Cash Accounts
Margin Accounts
Discretionary Accounts
There may be others that are particular to individual brokerages, but they will be variations of one of these three.
Cash Accounts
A cash account is the simplest type of brokerage account and the first one you will open.
Online and discount brokers will most likely require you to make a deposit with enough money to cover your trade before they will open your account. Many will place this money in an interest-bearing account until you are ready to trade. When you place a buy order, the broker transfers the money to the brokerage account to cover the trade.
When you sell a stock, the broker will deposit the proceeds in the account (unless you instruct them otherwise), so cash is available for the next purchase.
With a full-service broker, you may have three days to pay for your purchase depending on the broker’s policy. Trades must be paid for or “settle” within three days. This is called the “settlement date” and if you are a good customer with good credit, a full-service broker will give you those days to pay.
Some brokers allow you to pay for trades with a credit card, however unless you can pay off the balance as soon as you get the statement, don’t even think about doing this. No stock can overcome the 19% interest credit cards charge.
Margin Accounts
Margin accounts allow you to do just what I told you not to do with credit cards – borrow money to buy stocks, although under much more favorable conditions.
A margin account allows you to borrow up to 50% of the value of the stock from your broker when you make a purchase. For example, if you want to buy $10,000 of stock, you could write a check for $10,000 or with a margin account, write a check for $5,000, and borrow $5,000 from your broker.
By borrowing one-half the value of the stock, you can multiply your profits dramatically. Here’s how that works: If the price of the stock doubles to $20,000, your investment in the margin account ($5,000) has actually increase four fold.
With a margin account, you can make your money work harder, also known as using leverage and own more stock. However, there is risk. If the value of the stock falls instead of rises, your broker will issue a “margin call.” A margin call usually comes when the value of the stock falls below the value of the money lent to you by the broker. However, some brokers may have different thresholds for margin calls.
When you get a margin call, you have two options: You can deposit cash into the account to raise the value above the amount you borrowed or you can sell the stock immediately and pay off the loan. Some brokers may not give you the option of depositing cash, they may liquidate your position for you when the stock falls below a certain price.
Discretionary Account
Discretionary accounts give a broker or financial adviser the right to buy and sell stock without notifying you. If a broker wants this authorization, go find another broker. Unless you trust a broker or financial adviser with your life, never give anyone this type of control over you finances – it is the equivalent of a blank check.
There are circumstances when these types of accounts are appropriate; however, for most of us they are not only inappropriate, but also hazardous to our financial well-being.
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