In general, there are two types of brokerage accounts: cash and margin. A cash account is exactly what it says -- you deposit cash, you can invest it. No new cash, no new investments. A margin account on the other hand, allows you to invest without depositing more cash. Instead, you borrow the money from your broker. Neat, huh?! Not so fast, partner.
First, this type of brokerage account is not for beginning investors as it involves investing with money you don't own and you could wind up owing money you don't have. Second, the broker charges interest on the money it lends, so there also is that to consider. Third, this is the use of leverage and in 2008 we saw where that can lead. While things are good, you make out like a bandit. But when the bad times arrive, look out below. Your losses are magnified much more than if you had simply lost your own cash.
In a margin account, the cash and securities already present act as collateral for the borrowed funds. If the value of the collateral falls too low, then the broker will make a margin call, which is a forced repayment of some or all of the margin. Unless you provide funds to cover the call, the broker may and will sell securities from your account to raise cash and use that cash to pay down the margin.
Be aware that margin calls are a courtesy and not a requirement. Your broker can sell your securities without notifying you, getting your permission, or giving you time to put more money into your account.
The federal government, the individual stock exchanges, and the individual brokerages have rules governing who can open a margin account, how much can be lent to an investor (based on things like which stocks are involved and how much is in the account), and how much must be in the account (based on things like how much the investor has in securities).
On the upside:
You want to buy shares of XYZ, but don't have enough cash to buy as many shares as you want. No problem, you borrow $1,000 from your broker, add it to the $500 you already have, and buy 150 shares at $10 each. Six months later, you sell those shares at $25 (it was a good six months), return the $1,000 to the broker, and pocket $2,750. You turned your $500 into $2,750, a 450% return. This is much more than the 150% gain that the stock price itself had, reflecting the leverage effect of using margin.
On the downside:
Same scenario. Except this time, the stock tanks to $0.50 and you receive a margin call. You owe the broker $1,000 for something that is only worth $75. Oops! Because you can't scrape up $1,000 quickly enough, you sell all the shares of XYZ, along with shares of ABC, and JKL, both of which have also fallen, just to raise the $1,000 to repay the broker. On your $500 investment, you've lost $925, for a total loss of 185%. Plus, you're out on any future gains from ABC or JKL if their share prices recover. Ouch!
Shorting and margin accounts
If you want to short stocks, where you profit from a dropping stock price, then you must have a margin account. The process is complex and, again, not for beginners, but works something like this: The investor borrows 100 shares from the brokerage through the margin account. Since they were borrowed, the 100 shares have to be returned. The investor then sells the shares for $15 each (pocketing $1,500) and waits for the price to decrease. When it hits $10, she buys 100 shares back for $1,000 and returns 100 shares to the brokerage. She's made $500 using borrowed shares.
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