Like HowStuffWorks on Facebook!

How Online Trading Works


Opening & Funding an Account
With a cash account, you buy stocks with the money in your account. With a margin account, you can buy on credit.
With a cash account, you buy stocks with the money in your account. With a margin account, you can buy on credit.
Photo courtesy Pixel Perfect Digital

When you open an account with a United States online brokerage, you'll answer questions about your investment and financial history. These questions determine your suitability for the account you are requesting -- the brokerage cannot legally allow you access to investments that you cannot reasonably handle. You will also have to provide your address, telephone number, social security number and other personal information. This helps the brokerage track and report your investments according to tax regulations and the PATRIOT Act.

In addition to providing this information, you must make several choices when you create an account. With most brokerages, you can chose between individual and joint accounts, just like at a bank. You can also open custodial accounts for your children or retirement accounts, which are often tax-deferred. Unless you pay a penalty, you can usually retrieve earnings from a retirement account only when you retire.

Next, you must choose between a cash account and a margin account. You can think of a cash account as a straightforward checking account. If you want to buy something using your checking account, you have to have enough money in the account to pay for it. Using a cash account, you have to have enough money to pay for the stock you want.

A margin account, on the other hand, is more like a loan or a line of credit. In addition to the actual cash in the account, you can borrow money from the brokerage based on the equity of the stock you already own, using that stock as collateral. Then, you can buy additional stock. Your margin is the equity you build in your account.

According to the Federal Reserve Board, you must have at least 50 percent of the price of the stock you wish to purchase in your account. In other words, if you want to purchase $5,000 worth of stock, the value of the cash and stock in your account must be at least $2,500. You can borrow the other $2,500 from the brokerage.

Once you have made your purchase, you must keep enough equity in your account, also called your equity percentage, to cover at least 25 percent of the securities you have purchased. Here's how the brokerage determines this number:

  • The market value of your stock minus the amount of the loan you took to buy the stock is your equity amount.
  • Your equity amount divided by your total account value is your equity percentage.

If your equity percentage falls below the minimum, the broker has the right to issue an equity call. Typically, the brokerage will try to contact you, but the firm has the right to sell any and all of your assets to raise your equity percentage to the minimum. The brokerage is not obligated to contact you.

Margin accounts are definitely more complex than cash accounts, and buying on credit presents additional financial risks. If all of that sounds overwhelming, it's a good idea to stick with a cash account. If you'd like some more examples of how margin accounts work, check out the IORC's Investing Simulator Center.

Finally, you must decide how the brokerage will store your money between trades. Many brokerages offer interest-bearing accounts, so you continue to earn money even when you are not trading.

Once you have made all these choices, you must fund your account. You can make a deposit by check, make a wire transfer to the brokerage or transfer holdings from another brokerage.

When your account is open, you're ready to trade. We'll look at the trading process next.


More to Explore