Overview

Brokerage firms offer two primary account types: cash and margin accounts.

Cash accounts require customers to pay 100% of the purchase price for each securities transaction. They also prohibit strategies that involve unlimited loss potential (e.g., short sales). Cash accounts are the most common and widely offered account type.

Margin accounts allow customers to borrow money from the broker-dealer for investment purposes. They also permit higher-risk strategies. In fact, margin accounts are required for short sales and any other strategy involving unlimited risk (e.g., short naked calls).

When you borrow money to invest, you’re using leverage. Leverage can amplify both gains and losses. If the investment moves in your favor, your return can be higher than it would be using only your own funds. If the investment moves against you, your losses can be larger.

Imagine you have $5,000 of your own money and borrow another $5,000 from a friend. You now have $10,000 to use. Suppose you take the full $10,000 to the casino and bet it all on one game:

• If you win, the game provides a 100% return (your money doubles). Your $10,000 becomes $20,000, which is a larger gain than you could have earned if you had only bet your original $5,000.
• If you lose, you lose the entire $10,000. That includes your $5,000 and the $5,000 you borrowed and still owe back to your friend.

This illustrates the core idea of leverage: borrowing can increase your potential return, but it also increases what you can lose.

Borrowing money for investing works the same way. Margin can improve returns when the investment is “right,” but it can also magnify losses when the market moves against you. Because margin accounts involve considerable risk, they’re generally only suitable for risk-tolerant investors who can withstand significant losses.