It may seem trivial, but one of the most important decisions you're liable to make as an investor, and one that could wind up saving you substantial amounts of money, is deciding when and where to open a brokerage account.
Although there's nothing inherently wrong with allowing a financial advisor to handle your financial affairs, having your own brokerage account offers advantages. For starters, you'll be able to exercise your financial prowess and invest on your own with information that's clear and accessible. You'll always have access to your cost basis, and your tax information is straightforward and easy to comprehend. Having a brokerage account can also keep you personally involved and attached to your financial future, which is not always going to be the case if you solely rely on a financial advisor to handle your affairs.
If you have made the decision to open a brokerage account, or are at least considering doing so, keep in mind that there are a couple important questions you'll want to ask yourself, and perhaps the brokerage, before you commit to opening an account. You may well have more questions, but I believe these should be at or near the top of your list:
1. Is there a minimum deposit requirement?
The first thing you'll want to know is whether there's a minimum deposit requirement to open a brokerage account. There are about 15 online brokers you can choose from, and some require a certain amount of money before you can open an account while others don't.
On one end of the spectrum is Interactive Brokers with a minimum deposit of $10,000. That may sound steep, but for someone who's an active trader, the $0.005-per-share commission is very difficult to beat. However, since we at The Motley Fool preach a long-term ethos to investing, overall commission costs should probably play only a nominal role in your brokerage account decision process.
At the other end of the spectrum are a handful of brokerages that advertise no minimum deposit. This is particularly attractive for individuals who may feel discouraged about only starting out with a few hundred dollars. These future investors need to understand that no amount is too small to begin investing for your future.
Capital One Investing, previously known as ShareBuilder, has no minimum deposit requirement, and best of all, you can set up a recurring deposit every week, two weeks, month, or quarter that'll put a specific dollar amount into your account. Since timing isn't really an issue for the long-term investor, Capital One Investing purchases shares for you in the stocks you request on Tuesdays, even allowing you in some instances to buy fractional shares.
Of course, there are plenty of brokerages in between these extremes. Make sure you take the time to look into the deposit requirements and potential recurring deposit capabilities of the brokerages you examine.
2. Do you want a cash or margin account?
The second important question you'll need to ask and answer is if you want a straight cash account or if you want to open a margin account. There's no wrong answer as long as you understand the differences.
A cash account is exactly what it sounds like: an account where you can purchase stocks equal to the cash value of your account (plus the cost of commission). If you want to buy more stock(s), you'd simply need to add more money to your brokerage account.
What can't you do with a cash account? The big difference is you can't short-sell a stock or, in layman's terms, bet that it goes down, with a cash account. With cash only, you're betting on a bullish long-term future for your holdings. On the bright side, the most money you'll ever lose is what you've put into your account.
With a margin account, you have two additional ways of investing in the stock market over the cash account -- but not surprisingly, they come with added risks. The first method, as we just looked at, is short-selling. When selling a stock short, you never actually own the shares, which is why you need to be able to borrow money (known as margin) to bet against a stock. But here's the catch: Stocks can only go down by a maximum of 100% (they don't go below $0), but they can rise infinitely, meaning your losses aren't capped but your profits are when short-selling. Additionally, you owe interest on the money you borrow via margin. Margin rates can vary based on your trading history and account size, but at present, you'll typically pay between 7% and 10% in interest annually on money borrowed.
The other option with a margin account is to leverage up your bullishness. For instance, if you had a cash account with $2,000 and wanted to buy shares of a stock trading at $100, you could afford around 20 shares. With margin, you may be able to buy anywhere from 30-60 shares of that $100 stock using your $2,000 as equity for the borrowed money. If the stock goes up, you'll magnify your profits. However, just as with short-selling, you'll owe interest on the money you borrow, and if the stock moves in the wrong direction, you may wind up being sold out of your position or, worse yet, owing money to your brokerage firm.
Long story short, understand what your risk tolerance is and where your trading knowledge stands and choose accordingly. You can always change your account type at a later date, too.
3. Do you want the ability to trade options?
Finally, you'll want to talk to your broker about the potential for an options account. If you're scratching your head and wondering what "options" are, then the answer is pretty simple: Options aren't for you, at least not for the time being.
A stock option is a contract that gives you the right, but not the obligation, to purchase (known as a call) or sell (known as a put) 100 shares of a stock in question in the future by a specified date. Options can be a useful tool for seasoned investors to help hedge against existing stock positions in their portfolio. But there are a few finer points you should understand concerning options.
First, they have a very low success rate if you're not using them as a hedge. It's a commonly quoted figure, but around 85% of options contracts expire out of the money. This means they expire worthless. If you want to invest in options, you should understand that while the gains can be enormous, you'll often be wrong more than you're right.
Secondly, understand that you can trade options regardless of whether you have a cash or margin account. However, it's worth noting that your option trading strategies will more than likely be limited if you maintain a cash account. This can vary based on your broker, and it's something you should certainly look into if you plan to trade options.
Ultimately, opening a brokerage account doesn't have to be a scary process. Just keep these questions in mind as you work through the process and you'll find yourself taking those first steps toward financial independence.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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