At brokerage firms, there are two main types of accounts: cash and margin accounts. Cash accounts require customers to pay 100% for each security transaction and prohibit strategies that involve unlimited loss potential like short selling securities. Margin accounts allow customers to borrow money for investment purposes and allow risky strategies. In fact, margin accounts are required for short sales and any other strategy involving unlimited risk (like short calls).
When a customer borrows money for investment purposes, they leverage themselves. Leverage involves amplified gains and losses. Customers utilizing margin accounts are able to make more money when they make 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. If you win, you double your money to $20,000, which would make you more money than if you only had your $5,000. If you lose, you not only lose your $5,000, but also your friend’s $5,000 that you owe back to them.
Borrowing money for gambling works the same way as investing. Investors make more money if they make the right investment, but could lose more if they’re wrong. There’s a fair amount of risk involved with margin accounts, which is why they’re only suitable for risk-tolerant investors that can withstand losing significant amounts of money.
In this chapter, we’ll discuss how margin accounts work, the regulations that govern them, and how customers utilize them.
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