Choosing a broker to trade is unavoidable for retail traders. But the sign-up and set up process can be confusing for newcomers. Probably the first most confusing choice when signing up for a broker is the account type choice. Most brokers offer a wide variety of different account types. Just to mention a few: Individual, IRA, Custodial, Joint, (cash vs margin account)… All of them differ from each other, some a lot and some only in a few aspects. In this article, I will walk you through each and every relevant account type, so you know which is the best possible choice for you.
Broker accounts can be owned by one or more individuals or even companies. First of all, I will present the different standard individual account types, so the brokerage account types with only one owner. These are the most commonly used brokerage account types.
Individual Cash Accounts
The first and most standard brokerage account type is an individual cash account. Traders with this account type usually are allowed to trade all available asset types as long as there is enough money to cover the entire position. If a trader with a cash account wants to buy 100 shares of XYZ stock and XYZ is trading at $250, the trader’s buying power would be reduced by $25 000 (100 * $250). This may sound logical to some people. Theoretically, it makes sense that a trader should be able to cover his entire position with his own money. But this often leads to a very fast reduction in buying power, especially if you want to trade multiple assets at a time. If you want to trade many assets at once in cash accounts, you usually need a lot of capital.
Another clear disadvantage of cash accounts is that you can’t trade any naked options/undefined risk strategies. Selling options without protection, shorting stocks etc. are all things that aren’t allowed in cash accounts.
One definite advantage of cash accounts is that you can’t lose more money than you have in the account. This isn’t necessarily the case for all other account types.
Individual Margin Accounts
The next individual account type is the individual margin account. This is a little more flexible than an individual cash account because you don’t need to be able to cover your entire position’s purchase price. In margin accounts, you are able to borrow money from your broker. This might sound scary but as long as you know what you are doing, it isn’t that bad. As you can borrow money, your buying power is reduced much less per position than it would be in cash accounts. Trading multiple positions at once is much easier in margin accounts.
Let’s look at the example with stock XYZ again. The trader with a cash account had his buying power reduced by $25 000 for a purchase of 100 shares (XYZ’s price: $250). This same trade would only reduce the buying power by $12 500 or even less (depending on the broker) in a margin account. Thereby, a trader would save at least $12 500 of buying power which he can use for another position.
Selling naked options or shorting stocks (trading undefined risk strategies) is allowed in margin accounts.
Nevertheless, margin accounts have their disadvantages as well. One disadvantage is that you can lose more money than you allocated in some broker platforms. Therefore, you really should be aware of your risks in margin accounts. Never overleverage yourself/trade too big. Generally, margin accounts can have some additional rules to reduce the broker’s risk. To learn more about specific rules, I recommend asking your broker as this isn’t the same for all brokers.
Another popular individual account type is a retirement account. There are quite a few different individual retirement accounts (IRAs). The differences between these account types aren’t clear to most people. That’s why I want to present them now. Individual Retirement Accounts offer different tax advantages over standard individual account types. However, IRAs also come with some limitations. For example, you usually can’t use margin in IRAs. You typically can’t short sell stocks in IRAs either. Furthermore, most IRAs don’t allow you to sell naked options.
Traditional Individual Retirement Accounts allow you to deposit a certain amount of your income annually without paying taxes on it. However, when withdrawing gains made from this deposited money, you will have to pay taxes on it.
You can’t deposit income tax-free to Roth IRAs. But when withdrawing gains made from this money, you won’t have to pay any taxes on it.
These are the most common retirement accounts. In addition to them, there exist other IRAs for example, for self-employed people.
When picking an IRA, you should consider your income, tax bracket, expected return etc.
Joint accounts are account types owned by more than one person. Once again, there are multiple different Joint account types.
Joint Tenants with Rights of Survivorship
In this Joint account type, all owners own an equal share of the available assets/capital. Thus usually, all parties are able to allocate and trade with the deposited money. If one party passes away, all assets will be in full ownership of the remaining owner(s).
Tenants in Common
In this account type, both owners own a certain proportion of the deposited funds/assets. If one of the owners passes away, the other owner does not receive all assets of the deceased person.
Custodial accounts are another account that doesn’t necessarily have an individual owner. Custodial accounts are set up by a custodian who must be over the age of majority (usually 18). The custodian can manage assets on behalf of a minor. But note that all assets are owned by the minor. When the minor reaches the age of majority, the account and all its assets will be gifted to him/her. Before that, the minor is normally not allowed to place trades. All trading has to be done by the custodian.
A trust account is an account in which a trustee controls the funds/assets for the benefit of another party. The trust can be in their own name or the name of another individual. They can be especially useful in estate planning, as they generally bypass the probate process and can deliver assets to beneficiaries fast.
Corporate accounts can be opened by legal entities/corporations. To set up a corporate account, you will need a Corporate Agreement, Tax ID number and more. Corporate accounts usually are used by one or more authorized corporate officers that may trade on behalf of the corporation. Usually, corporate accounts, if set up correctly, don’t have margin restrictions.
Conclusion – What Account Type Is Right For You?
This obviously depends on you! But as long as you just want to trade with your own money for yourself, you probably should open an individual margin or cash account. If you want to save up for your retirement and want to enjoy tax benefits, you could also open an Individual Retirement Account. But remember that these can come with restrictions. Therefore, there is no one right account type for everyone. It really depends on personal preferences (trading style, goal, situation, time…)
Note that not all of the discussed brokerage account types are available in all countries. The discussed account types should all be available in the US. But something like an individual cash or margin account is very likely available in your country as well.
Furthermore, not all brokers offer all account types. You have to check the desired brokers website or contact their support to find out if they offer your account type. But once again, almost every broker should offer individual margin and cash accounts. Some of the account types may also have further or fewer restrictions depending on the broker. For example, Tastyworks (my preferred broker) allows you to sell naked calls in IRAs. So make sure to ask your broker.
What Is The Best Brokerage Account Type For Options Trading?
For options trading, I really recommend an (individual) margin account. This is because an option trader needs the flexibility to both buy and sell options. Selling options isn’t allowed in most other account types. This reason alone is enough for me to recommend margin accounts over all other account types (for option traders).
The Broker Tastyworks Offers All The Above Broker Account Types. You Can Read My Tastyworks Review Here!