Four Strategies for Margin Experienced Investors Should Consider

Once you’re comfortable, here are four advanced margin strategies to consider.

1. Pairs Trading

Pairs trading is based on a simple statistical approach: If two securities are somehow related, most of their stock ups and downs will likely be tied as well. But that isn’t always the case — and when that relationship deviates from the norm, there’s an opportunity for a successful trade.

With a pairs strategy, you use advanced statistical techniques and quantitative models to identify linked assets, whether they’re stocks, commodities, or even currencies. While they may move together historically, you’re looking for instances where two assets may have temporarily diverged.

Once the pair is chosen, you take a long position and buy shares in Alpha Company, the one that is expected to outperform in the near term. Meanwhile, you also assume a short position to sell shares in Beta Company, the one which is most likely to underperform. Over time, you’re expecting the prices of the two assets will shift back toward their historical relationship.

For example:

By employing margin funds, you keep dollars available to make those linked purchases without selling other assets to generate the needed capital.

“You are short on one and long on the other, so your overall market risk should be reduced. But there is no rule on when and how long these deviations last, so be careful,” margin expert Paul Anderson, CEO of OpTech UK said. “The expense of this trade depends on your cost for the pair and how long the trade will last.”

2. Margin Pyramiding

If you’ve got a good thing going, you want more of it, right? That’s the principle behind margin pyramiding. In this strategy, you closely monitor a trade that’s moving in your favor. As it grows, you use margin funds to increase your position size.

As the asset continues its climb, you continue borrowing funds and adding to the position. Each time capital is added to the position, you’re effectively leveraging existing profit to amplify further profits.

Of course, there is a downside: At some point, even a climbing stock’s upward surge will falter. So Anderson warns it’s important to be ultra-vigilant to minimize potential losses if a trade reverses.

"I equate this with taking equity out of your house to buy another house. As the value increases, you take out more of the increased equity to buy more houses on margin. Pyramiding is a good word for this. But again, the more you do, the greater the reverberations from any smaller move or risk," Anderson said.

3. Volatility or Event-Driven Trading

With both volatility and event-driven strategies, you’re using the choppy waters of the market and their wake to your advantage. When doing so, you may consider amplifying your edge with quick and easy access to margin funds.

Volatility trading focuses on exploiting price swings caused by standard, yet sometimes aggressive market ups and downs. Event-driven trading works the same way, but often is driven by Wall Street events like new earnings reports, product launches, or economic data releases.

In both cases, these situations may lead to price movements on a security, while margin funds allow traders to boost potential gains.

Say you think Alpha Company stock price is low based on its historical levels ahead of its quarterly earnings report. You could employ options trading, buying an at-the-money (ATM) straddle to hedge against either positive or negative results. With a straddle, you purchase call and put options with the same strike price and expiration date.

Here’s how it would work:

• You’d purchase an ATM call option with a strike price of $50 at a cost of $3 for the contract.
• You’d also buy an ATM put option at the same $50 strike price and $3 contract fee.
• The total cost of your straddle is just $6.
• Once the stock's earnings report is released, you track the results.
• If the stock goes up or down significantly based on the earnings news, either your call or put option will increase substantially.
• That increase should be enough to outweigh any loss on your other option, leaving you with a net profit.

Once again, caution needs to be taken. Anderson points out this attempt to reap short-term price movement gains requires even more careful timing than most.

“I really like these trades. They’ve gotten very popular with the introduction of shorter dated options,” Anderson said. “You are maximizing your leverage of the option here. But it is hard to get all three – your direction, duration, and magnitude – correct. But if you do, your gains will be outsized. These trades can use many different strategies and you’re looking at magnitude of movement. Will XYZ move X% on the earnings date? And keeping risks contained is possible, but not really necessary on all these trades, so the cost will vary.”

4. Short Selling With Margin

Think a stock is heading down? Short selling on margin allows you to borrow that asset via margin funds, sell it at the current price, then buy it back later at a lower price to make a profit.

This is how it plays out:

• If you believe Alpha Co. stock is overvalued and primed for a fall, you’d engage your margin account to borrow 100 shares of Alpha, which currently sits at $50 per share.
• That means the value of your borrowed shares is $5,000.
• You would then sell your $5,000 stake in borrowed shares on the open market.
• The result: Getting back your initial $5,000 investment.

It’s also important to remember that, throughout this strategy, you’ll likely need to always keep a maintenance margin in your account, which could equal about 30% of the total borrowed value.

If the price of Alpha stock declines as you projected to $40 per share, you could then buy back those shares at the current market rate of $40 per share at a total cost of $4,000.

While you received $5,000 to buy the borrowed shares, you only spent $4,000 to close out your short position, leaving you with $1,000 of profit, minus any brokerage fees.

The Secret to Margin Trading

As is usually the case when making trades with borrowed funds, be alert to market changes. A stock price’s rise instead of a fall could leave you holding a significant loss and potentially facing a margin call, which would require you to deposit additional funds into your margin account.

“To sell stocks short, you need to work with margin,” Anderson said. “You may think they will go down, but it can be very costly to use these credit lines. If you want to pre-place short stock, you can also just use puts.”

To get started with margin, watch our video to find out more or open a Self-Directed Trading account.

Investors can place commission-free stock, ETF, and mutual fund trades through Axos Invest from any device, anytime. Get started with your new Self-Directed Trading portfolio today.