Brokerage, cash and margin accounts: what's what?

You can tell a cash account from a margin account and explain what each one means for how much you can lose.

One box changes the risk

Opening a trading account takes a few minutes: name, address, a few questions about your experience, and a choice of account type. Many people click through that last step without thinking about it.

Yet that choice decides something important: whether you can only lose the money you put in, or more. This lesson explains the account types you will meet, in plain terms, before you open one.

What the account holds

A brokerage account holds the securities you own and the cash you use to buy them. Some brokers show it as one account. Others split it into a securities account and a linked cash account. Either way, the broker keeps a record of what is yours.

How you are allowed to pay for trades depends on the account type.

Cash account. You trade only with money that is already in the account, and you pay the full price of what you buy. Your possible loss on a share is what you paid for it. In the US, the SEC explains that selling a security before you have paid for it is called freeriding. The broker can then freeze the account for 90 days, during which you must pay for every purchase in full on the day you buy.

Margin account. The broker lends you money, using your securities as collateral. That lets you buy more than your cash would allow, and it is also needed for short selling. The SEC lists the costs and risks:

You pay interest on the loan.
The broker sets a minimum of your own money in the account. If losses push you below it, you get a margin call.
The broker can sell your holdings without contacting you first, and you do not choose which.
You can lose more money than you deposited.

Leveraged products such as CFDs usually run in their own type of account, with their own margin rules. You met them in the lesson on leverage.

Your money or theirs

Two traders each have 10,000 and buy the same fictional stock.

Cash account: 10,000 of shares. The stock falls 30%. The position is worth 7,000. The loss is 3,000, or 30% of the money.
Margin account: 10,000 of their own plus 10,000 borrowed, so 20,000 of shares. The same 30% fall cuts the position to 14,000. The loan of 10,000 is still owed, so only 4,000 of their own money is left.

The second trader has lost 6,000, or 60% of their money, plus interest. The broker will probably ask for more money or start selling. If the stock fell 50%, the position would be worth 10,000, exactly the loan. All of the trader's own money would be gone, and a further fall would leave a debt to the broker.

Common mistakes

Not knowing your account type. Some brokers offer margin as an upgrade or switch it on during sign-up. Check your settings.
Treating buying power as your money. A margin account may show more buying power than your cash. Part of it is a loan.
Selling before paying in a cash account. In the US, this can freeze the account for 90 days.
Forgetting the interest. Borrowed money costs money every day you hold the position.
Opening the wrong account for your plan. If you only want to buy and hold, a cash account removes a whole category of risk.

The takeaway

A cash account trades only with money you have. A margin account lets you borrow, which raises the possible loss beyond your deposit.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the account in which you can lose more than you paid in.

Tap the chart.

With borrowed money, losses are measured on the whole position. The SEC warns that you can lose more than you deposit.
2In a US cash account, you buy a share and sell it before you have paid for it. What can happen?

The SEC calls this freeriding. Under US rules, the broker can then require full payment upfront for 90 days.
3What does a broker do in your margin account when your equity falls below its minimum?

The SEC notes that brokers can sell securities in a margin account without consulting you, and you do not get to choose which.
4What does a brokerage account hold?

A brokerage account keeps your securities and cash. Some brokers split this into a securities account and a linked cash account.

of 4 correct.