The Best and Worst Ways to Margin Trade

Everything you want to know, broken down

Source: Kelly Sikkema on Unsplash.

Among the myriad services that brokerage companies offer, one of them is allowing you to trade on margin.

Margin comes as a standard option you can choose when you complete your application for any brokerage account, whether that’s Robinhood, Ameritrade, Fidelity, or Interactive Brokers.

Margin is the money borrowed from a brokerage service to purchase an investment; that could be in the form of equity (stock), derivative (movement on the price of the stock), or futures (commodities, futures options, etc).

In shorter words, to margin trade is to take a loan. The amount of loan you can continuously borrow along a time period is what’s called your margin requirement or maintenance margin. This is the amount of money you need to have in your account in equity — either stock or cash — going forward so that the brokerage service doesn’t feel worried about your ability to cover your loan. If you have mostly stock equity, this number will change as the stock value changes. If you have mostly cash, this number stays right about the same.

Margin borrowing is backed by your very own cash and stretched by the amount of leverage you desire. It’s your ability to financially reach what you otherwise couldn’t.

And this is where a lot of the dilemma begins.

Leverage, the blessing the and curse.

Comparing different anecdotal forms of leverage.

Leverage is one of the greatest tools in our investing toolbox. When it works to our favor, it’s magical and unreal. The compounding effect is nothing short of awesome. It has the ability to multiply gains because you can always find a price point to infinitely push your leveraging multiplier up.

However, that doesn’t come without consequences. The farther up you push that leverage, the less predictable that payoff generally becomes. The likelihood of you losing will, mathematically, increase.

When you add borrowed money to that mixture, you’re fueling something that’s chaotic and random.

John Meynard Keynes said, “Markets can stay irrational longer than you can stay solvent.”

The most difficult thing is nailing the science of movement over time. For every derivative trade betting bullishly, there is an equal and opposite trader on the other end of that transaction. Most brokerage services have built-in systems that automatically notice the amount of leverage and act in defense of their money you’re borrowing.

As soon as you go under, you will be hit with the infamous margin call; this is where the brokerage service forces you to either liquidate some of your risky holdings or add more funds into the account. If you don’t make a decision, the brokerage service has every right to liquidate your holdings for you.

Naturally, the only long-term stories you will have for margin-trading accounts will be the success stories. In the long-run, most daytraders lose money — meaning, if any of them have any margin, they will lose some or all of that, too. This leads, naturally, to survivorship bias, where the only traders that continue on are the ones that withstand the irrationality of the market for a long enough period.

These are the people who use their margin

  1. responsibly.
  2. with less leverage and a larger margin of safety.
  3. sparingly.

Otherwise, margin trading is the analog of a casino in the form of pressing buttons on the internet or phone.

Buying what you love without the purchase.

This is a personal favorite.

In the past, after reading countless annual reports for companies that I love, I will want to fully commit to purchasing them. Except, I’m not sure about the intricacies of going in fully at a current price-point.

I want to use my toolbox to my advantage.

Even if I have cash in my account, I will opt to sell puts on the equity.

In the past, I did this for Smart & Final, a small, big-box grocery chain in the Southern California area that I live. I knew that business and the model very well. I knew that they competed at excellent price-points and they offered a better bargain than the other grocery chains in the area. They were deflated in stock price because of a failed mid-west expansion they attempted a few years back. Outside of that, they competed on every level with the bigger grocers.

They were better than Costco because you didn’t need a membership and their prices were similar.

They were better than Kroger because they offered larger box items at a significant discount to make it appealing.

Chart for SFS, pre-privatization.

It had been deflated over the years from a high of $20s. What I ended up doing is selling puts on SFS between $6 and $5 over the length of a year at a frequency of once a month. The vast majority of these trades never involved exchanging the contracts for shares. This is because the contract would expire at a high point, rendering the opposing trader’s premium worthless.

In the case where Smart & Final would go under my strike price, I would love to purchase the company anyway. I was going to be a long-term investor in the company for many years forward. I thought there was significant growth for this grocer, and, my thoughts weren’t wrong.

They were taken private by a private equity firm for $1.12 billion. It seems like another group of individuals saw the value and had the same idea. My shares were bought out, and now the stock ticker doesn’t exist anymore.

My cost basis for Smart & Final was right around $5.50 for the shares I owned. It went private for $6.50 a share. Outside of the stock sale, though, I made money feeding short-sellers via put sales.

The general theme is simple: Find something you love and believe in and feed the people trying to short the stock via a put purchase. This does two things for you:

  1. If the stock doesn’t fall and stays the same, you win the entire premium.
  2. If the stock falls but stays within the premium range — i.e. if you sold a $5 put on SFS for $.35, and the stock price is $4.85 at expiration — you make money.
  3. If the stock price falls but not too far away from your premium range, you wanted to buy the stock anyway and bought it at a discount from before — again, imagine selling a $5 put on SFS for $.35, your effective buy-rate for SFS is now $4.65 a share instead of the $5 a share you would have purchased it at before.

Margin accounts, and the underlying brokerage firms, understand the implicit risks tallied with each trading style. This is one of my favorite ways because, in addition to my available cash or underlying equities, it helps me transition my portfolio without moving the stocks directly.

Location, location, location. On discovering long tails and mean reversion.

A general concept, mathematically speaking, we want to introduce to a system of margin trading is its ability to consistently bring on decent money while offering up very little of our own capital.

Minimization-maximization is easy to think about, as a concept. In application, and in the real world, it can seem chaotic. Systems that are designed not in prediction, but, rather, in a long-term win strategy work best.

The current pandemic was a great example of how to find a method in capturing gains in mean reversion without liquidating a portfolio.

Source: Chart courtesy of S&P 500 index and the massive “V” shape from February to present.

The S&P 500 took a nearly 40% free-fall from its all-time high in February. Most traders will opt to sell off their holdings in hopes of buying back at a better price. As a concept, that makes sense. In reality, nobody understands when we should expect the recovery to happen.

Margin trading opens up the ability to sell puts as the prices of individual equities begin to bottom out or even afford small, bullish options on the way up. When margin trading, you can make a few hundred dollars work wonders when you are placing bets far out-the-money in hopes of a recovery.

In the case where you are selling puts, you benefit from outrageously high premiums because of the added volatility. Selling calls on the VIX and selling puts on Boeing are two things I did, for example, to help create positive cash-flow on the edge of my portfolios.

Selling VIX calls on one of my portfolios for approximately two months week to week. The strike points on the calls range from 37.5 down to 30. Almost every week it either expired out the money or it was nearly worthless.

In those instances, your portfolio shouldn’t take a hit from unforeseeable changes in the future if you place a bet in the incorrect position. Gargantuan leverage is bad only when the amount of cash you are leveraging is equal to a decent chunk of your portfolio size. Otherwise, betting on the liquidity and health of a market is never a bad thing — it’s simply a bet on the return to normalcy, which is expected. Should you stay liquid for a long enough time period,— a week to a year—then your portfolio will end up at a better place than before the pandemic. In our case, the stock market recovered with instantaneous force. While this didn’t need to be the case, those who bet on a rebound were allowed to hold on to their original equity and create additional capital through their access to margin. They also benefit from the tax implications of not frequently buying and selling their larger holdings.

Are we homoskedastic yet?

The myth-making of the 5,000 dollar millionaire is born out of margin trading. Whether that is Reddit’s WallStreetBets or the advertisements for any stock advisor telling you that you can make 20,000% on the next stock pick, people confuse heteroskedasticity for true intelligence all the time.

What is heteroskedasticity?

It is a concept in unequal variability. Specifically, when the variable that’s being predicted is predicted unevenly or inconsistently along the range of values on the predictor.

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Illustration of homoskedasticity (on the left) and heteroskedasticity (on the right).

Contrasting that with homoskedasticity, where the variable doing the predicting (and its error) is consistent and even along the predictor.

You’ll hear stories of people making a million dollars from $10,000 — with the help of margin trading. You’ll hear the story of the same person losing it all within the same month.

There is everything from people not understanding how margin works, to people leveraging their entire portfolio for options that expire in two weeks, to people who have made a ton of money and lost it all within a few short months.

Ultimately, margin trading isn’t a science. Most trades, in the short-run, are nearly impossible to categorize into one of a homoskedastic or heteroskedastic nature. Besides that, however, one needs to always understand that margin trading is something you are willing to lose — mostly because you’ll have the ability to either cover that loss or you’re willing to sell something in your portfolio anyway.

Written by

UC Berkeley, mathematics. Los Angeles. Long-time runner. Top writer on Quora, 100M+ total content views. New to Medium. Inquiries:

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