If you are considering investing in the stock market, opening a brokerage account is the first step toward building a healthy investment portfolio. A brokerage account makes it possible for a professional broker to buy or sell stocks, bonds, mutual funds and other investments on your instruction – all for a fee. The commission collected by your broker differs based on whether your account is with a discount brokerage or a traditional brokerage.
A traditional brokerage provides a wide range of financial services, offering advice with regard to what investments they feel will be right for you. The traditional brokerage service carries a much higher price tag than the discount brokerage, where a broker merely carries out the investor’s instructions and charges a commission for doing so. There is no standard brokerage commission structure, so it is worth it to shop around for good rates before making your decision.
Once you have decided on a brokerage firm, there are three kinds of brokerage accounts you can choose from, namely cash, margin or discretionary. With a cash brokerage account, there needs to be sufficient money in the account to cover the trade, plus commission, at the time of its execution. Alternatively, some brokers will allow the investor to pay for the trade within three days, which is referred to as the settlement date. Although most brokerage firms require cash or a personal check to fund a cash account, there are some who will accept credit cards.
The second type of brokerage account is a margin account. This allows an investor to buy securities with money borrowed from the brokerage. This is limited by the Federal Reserve to a maximum of 50% of the amount invested and some brokerages have stricter limits depending on whether the stocks being bought are considered stable or volatile. The interest charged on margin loans is kept relatively low in an effort to encourage investors to make use of a margin account. The way it works is that if, for example, you wanted to buy 20 shares at $50 each, you would need $1000 (plus commission) to complete the purchase if you were making use of a cash account. But if you have a margin account, you will pay $500 and the balance is paid by the broker (working on a 50% scenario). If the stock then goes up to $75 you will earn $500 as profit, i.e. 20 shares x $75 = $1500 minus $500 paid back to the broker, leaves you with $1000, being 100% return on your $50 investment. With a cash account, your return on investment would have been 50% because you would have put up $1000 at the time of purchase. However, investing is seldom that simple, and if the stock falls the broker can issue a margin call. This will oblige you to either raise the value of the money borrowed by depositing cash into the account, or you can sell the stock to pay off the loan from the broker.
The final option available is a discretionary account, which gives the brokerage the authority to buy and sell stock on your behalf without notifying you. This is tantamount to handing over a blank check which requires the type of trust between yourself and the broker which can generally only be built up over years of trading – definitely not a wise option for beginners.
