Overview

Brokerage firms offer two primary account types: cash and margin accounts. Cash accounts require customers to pay 100% for each security transaction and prohibit strategies that involve unlimited loss potential (e.g., short sales). They are the most common and popular account type offered by broker-dealers. Margin accounts allow customers to borrow money for investment purposes and perform high-risk strategies. In fact, margin accounts are required for short sales and any other strategy involving unlimited risk (e.g., short naked calls).

When customers borrow money for investment purposes, they obtain leverage through amplified gains and losses. An investor utilizing margin may make a higher return when they choose the “right” investments, but also are subject to more losses when the market moves against them.

Imagine you have $5,000 of your own money and borrow another $5,000 from a friend. Then, you take all $10,000 to the casino and bet it all on one game. The game provides a 100% return (doubles your money) if you win, but takes away your money if you lose. With a win, you turn the $10,000 into $20,000, a better return than if you only started with your $5,000. A loss results in you losing your $5,000 and your friend’s $5,000 that you owe back to them. This is a good example of how leverage works.

Borrowing money for gambling works the same way as investing. Investors make a better return if they make the right investment, but also lose more if they’re wrong. Margin accounts are subject to considerable risk, so they’re only suitable for risk-tolerant investors who can withstand losing significant amounts of money.