Brokerage Account

A brokerage account is an investment account at a brokerage firm, through which individual investors can typically access a wide range of securities, including stocks, bonds, and exchange-traded funds. The amount of control the investor maintains over the investments varies based on the type of account in which the investor has enrolled. Many online or discount brokerage accounts serve simply as conduits through which investors can buy or sell stocks or other securities; in such cases, the investor usually pays the brokerage firm a small fee in exchange for access to the firm’s trading portal and limited informational resources. Other brokerage accounts may be actively managed by the brokerage firm itself, allowing the account’s owner to take a more hands-off approach to investment and benefit from the firm’s financial experience. Such accounts usually command significantly higher fees. Brokerage accounts can also be divided into three types—cash accounts, options accounts, and margin accounts—based on the investing privileges for which the individual investor has been approved.

Background

For hundreds of years, brokerage firms and individual brokers have assisted individuals in making their investments, facilitating the purchase or sale of stocks, bonds, and other securities. In the United States, brokerage firms increased in popularity in the nineteenth century, following the establishment of major stock exchanges such as the New York Stock Exchange. During the twentieth century, the widespread presence of telephone technology allowed investors to call their brokers and conduct transactions by phone, thus enabling them to respond quickly to changes in the markets. It was the rise of the Internet, however, that had perhaps the greatest effect on the development of twentieth- and early twenty-first-century brokerage accounts. As individuals increasingly used the Internet to manage their finances, a number of online brokerage companies were established. Such companies, sometimes known as discount brokerages because of their low fees in comparison to full-service firms, enabled account holders to manage their investments online. Full-service brokerage firms continued to prosper, as many investors preferred the expert guidance and access to experienced financial professionals that such firms typically offer. However, online brokerage accounts proved ideal for new or casual investors who appreciated their low fees, as well as for experienced investors seeking to assert more control over their individual investments. In light of those changes to the investment world, some established firms took a hybrid approach, offering both traditional, full-service brokerage accounts and self-managed accounts with low fees and less professional guidance.

Despite their differences, both forms of brokerage accounts represent a significant potential risk to investors. Full-service brokerage accounts employ numerous advisers and account managers dedicated to helping investors make prudent financial choices. However, unscrupulous firms or brokers could potentially influence investors to make decisions that are not in their best interest; for instance, a broker paid on commission could encourage investors to perform transactions that garner him or her the highest commissions rather than those most beneficial to the clients. Online brokerage firms raise similar concerns regarding fraud and financial mismanagement, although, as they typically do not offer expert investment advice, the possibility of conflicts of interest or related issues is generally considered less of a problem. However, by allowing investors to perform transactions directly, self-service brokerage firms could potentially enable inexperienced individuals to assume an inordinate amount of risk. Due to those concerns and others, both full-service and online brokerage firms are subject to regulation by government entities such as the Federal Reserve Board, governing organizations within the financial industry, and entities within the brokerage firms themselves. Many of the restrictions an investor might encounter while investing through his or her brokerage account originated in government or industry regulations.

Overview

When choosing a brokerage firm with which to open an account, an investor must consider a number of factors. First, the investor must consider his or her knowledge of investing, understanding of the various financial instruments available, and general familiarity with the types of transactions he or she wishes to conduct. The investor must also factor the amount of time and energy he or she can put into researching investments, as well as his or her financial goals and comfort level regarding financial risk. Finally, the investor must also determine what level of fees he or she can afford to pay. Careful consideration of such factors will assist an investor in choosing a brokerage firm. Investors who can afford high fees, have busy schedules, and would benefit from expert advice and assistance may choose to open an account with a full-service brokerage firm, while those who prefer to perform their own research, respond immediately to fluctuations in the market, or simply spend little money on fees may prefer an online or discount broker. Still other investors may feel most comfortable opening an account with a hybrid company that allows investors to manage their investments themselves but also offers broker-assisted transactions and expert advice on an optional, as-needed basis.

When opening an account with nearly any firm, an investor must typically complete a form or application that provides the firm with information about his or her finances, as mandated by federal regulations. For example, the investor must often provide his or her employment details and current salary and may also need to reveal information about his or her net worth and liquid assets. The initial paperwork typically also includes questions regarding the new account holder’s investment goals and attitude toward risk, which are crucial factors that influence the types of investments a person makes. An investor who hopes to generate income may be willing to make high-risk, speculative investments in order to do so, while another investor, perhaps one nearing retirement, may prefer more stable, low-risk investments that promote steady growth.

Most brokerage firms offer several different types of accounts. Cash accounts are the most basic form of brokerage accounts and are generally considered the most appropriate for novice investors, although experienced investors may use them as well. An investor who has a cash account can pay for stocks or other financial instruments only with the liquid funds available in the account. The holder of a cash account is not permitted to borrow funds from his or her brokerage firm, and the types of financial instruments he or she is permitted to trade may be limited. Although cash accounts offer limited privileges, they are well-suited to basic investing and can be upgraded to less limited types of accounts as the investor gains experience and confidence.

Options accounts allow a brokerage firm’s clients to buy and sell options, which are essentially contracts to buy or sell a particular number of shares of stock for a certain amount of money by a specified date. Such contracts can be separated into puts and calls: a put is a contract to sell shares of a stock under those specific conditions, while a call is a contract to buy shares of a stock. Options trading allows investors to speculate on the movement of the stock market and to hedge, or reduce the risk of loss from a particular investment. Because options trading is a more advanced, active form of investing, investors with basic brokerage accounts are typically not automatically permitted to engage in the practice. To open an options account, or to add options-trading privileges to an existing account, an investor must typically complete paperwork in which he or she acknowledges the risks inherent in that form of trading and provides his or her income and years of investment experience. Some firms also require the investor to have a minimum amount of money in his or her account. After submitting the application, the investor, if he or she meets the firm’s requirements, will be approved to engage in some or all forms of options trading. Options accounts and other forms of brokerage accounts are not mutually exclusive; the holder of a cash account may be granted options-trading privileges, and an investor with an options account may also be permitted to trade on margin. While many brokerage firms offer options trading as one of their many investment services, some firms specialize in this form of trading, and an experienced options trader may find that an account with such a firm best suits his or her investment strategy and needs.

Margin accounts are unique in that they allow investors to purchase securities such as stocks with money borrowed from the brokerage firm. This investment strategy allows investors to take advantage of changes in the market without initially putting as much money at risk. Trading on margin is highly risky, for if the price of a security purchased on margin decreases, the investor not only loses money on his or her investment but also owes money to the firm. Margin accounts also often grant investors the ability to short sell a stock. In that process, the investor borrows shares of stock from the firm and sells them. If the price of the stock then goes down, the investor buys an equal number of shares at the new price and returns them to the brokerage firm, keeping the remaining funds as profit. If the stock’s price increases, however, the investor will have to spend more money than he or she made from the sale to replace the firm’s shares. Because of the risks associated with such trading strategies, firms usually restrict margin privileges to experienced investors and typically require investors to have a minimum amount of funds or securities in their accounts.

Bibliography

“About BrokerCheck.” FINRA, www.finra.org/investors/investing/working-with-investment-professional/about-brokercheck. Accessed 19 Dec. 2024.

Bajpai, Prableen. “A Guide to Day Trading on Margin.” Investopedia, 23 May 2024, www.investopedia.com/articles/active-trading/071114/guide-day-trading-margin.asp. Accessed 19 Dec. 2024.

Bernstein, William J. The Four Pillars of Investing. McGraw, 2010.

“Brokerage Accounts.” FINRA, www.finra.org/investors/investing/investment-accounts/brokerage-accounts. Accessed 19 Dec. 2024.

Chen, James. “What Is a Brokerage Account? Definition, How to Choose, and Types.” Investopedia, 7 Oct. 2024, www.investopedia.com/terms/b/brokerageaccount.asp. Accessed 19 Dec. 2024.

Downey, Lucas. “What Is Options Trading? A Beginner's Overview.” Investopedia, 15 Nov. 2024, www.investopedia.com/options-basics-tutorial-4583012. Accessed 19 Dec. 2024.

Hayes, Adam. “Short Selling: Your Step-by-Step Guide for Shorting Stocks.” Investopedia, 25 Oct. 2024, www.investopedia.com/terms/s/shortselling.asp. Accessed 19 Dec. 2024.

Murphy, Chris B. “Margin Account: What It Is, How It Works, Example.” Investopedia, 29 Apr. 2022, www.investopedia.com/ask/answers/200.asp. Accessed 19 Dec. 2024.