Overview

At brokerage firms, there are two main types of accounts: cash accounts and margin accounts.

Cash accounts require you to pay 100% of the purchase price for each securities transaction. They also prohibit strategies with unlimited loss potential, such as short selling.

Margin accounts let you borrow money from the brokerage firm to invest. Because borrowing increases risk, margin accounts are required for short sales and other strategies with unlimited risk (such as short calls).

Leverage and why it matters

When you borrow money to invest, you’re using leverage. Leverage can amplify both gains and losses:

• If the investment goes your way, you can earn more than you could with only your own money.
• If the investment moves against you, your losses can be larger - and you still have to repay what you borrowed.

A simple example

Imagine you have $5,000 of your own money and borrow another $5,000 from a friend. You now have $10,000 to use.

• If you take all $10,000 to the casino and win, your money doubles to $20,000. That’s a bigger gain than you could have made if you’d only used your $5,000.
• If you lose, you lose your $5,000 and your friend’s $5,000 - and you still owe your friend the $5,000 you borrowed.

Borrowing to invest works the same way. You can increase your potential return, but you also increase your potential loss.

Because margin accounts involve this added risk, they’re generally only suitable for risk-tolerant investors who can withstand significant losses.

In this chapter, you’ll learn how margin accounts work, the regulations that govern them, and how customers use them.