What is Margin Trading?
Margin trading is a type of trading that uses borrowed funds or assets provided to the trader on credit against the agreed amount of collateral, which is called “margin”. This trading mechanism is common in both traditional finance and cryptocurrency markets, and it is used to gain access to greater financial resources, thereby leveraging and potentially amplifying the traders’ profits. In traditional financial markets, the loan is typically obtained from an investment broker. In the cryptocurrency market, the funds are usually provided by the cryptocurrency exchange.
Although there are similarities between cryptocurrency trading and trading on traditional markets, there are also some differences, which we will briefly describe in the next section. We will also explain the basic principles and components of margin trading, as well as the advantages and disadvantages of this strategy, so you could decide if it is right for you.
Traditional Vs. Crypto Trading
More and more people are flocking to the cryptocurrency markets in the hope of making a profit from buying and selling digital assets. Some of them come to the industry, believing that trading crypto is just like trading fiat or stock – a notion that is not entirely wrong. However, although there are many similarities and overlaps in basic concepts and approaches, they are also several notable differences. Let’s briefly talk about them.
Unlike foreign exchange or stock markets, which only have trading “sessions,” with a break for weekends and holidays, crypto business is happening 24/7 and is not limited by geographical boundaries. As a digital asset class, any cryptocurrency in existence can be bought and sold any time, anywhere, using a crypto exchange that lists the specific currency pair – and thanks to this quality, this market is even more dynamic than traditional markets, operating at virtually breakneck speed.
Moreover, entering the cryptocurrency market is much easier for an average user than getting into fiat or stock trading, where there are mounds of paperwork to be filed and substantial initial costs before you can even place your first order. And even then, it can take a pretty long time before you can show a profit – assuming that you keep abreast of various data points involved in staying in the green, such as political situation, breaking news items, economic developments, etc.
But the cryptocurrency marketplace is much more accessible for a beginner: you can start trading with just $100 or less in cryptocurrency and endeavour to earn a profit from a market that is pretty volatile compared to the traditional markets, which means that, although the risks might be higher, the rewards may also be more satisfying and attainable.
Speaking of risks, this is another factor that both the traditional and cryptocurrency markets share: the need for reliable risk management strategies to keep you from going broke. If the market does not go the way you expect, you can be in the red in the blink of an eye. We will talk about the risk mitigation approaches further on.
Both markets rely on a vast array of trading approaches and strategies, many of them shared, such as day trading, long-term trading, scalping, stop-loss, etc. One of these overlapping approaches is margin trading.
How Does Margin Trading Work?
As we mentioned in the introduction, in margin trading, you borrow capital from other market players to trade cryptocurrencies taking advantage of the higher leverage. The main reason you might want to do this is if you believe that the market is going to move in a particular direction, and you want to maximize your profits.
By way of example, let’s imagine that you are looking to buy a particular cryptocurrency whose price, you believe, is going to go up. Unfortunately, all you have in your trading account is the $100 you entered the market with. If only you had access to a bit more capital, you know you could derive more profit, as long as the market delivers. This is where trading on margin comes in handy: you could use your $100 as collateral to secure a loan from the exchange and, by borrowing another $100, you will then have $200 to work with. If the price of the currency you’re betting on fluctuates as you predicted, your profits will double. You will then pay back the loan (along with the interest rate and trading fees) and keep the profit.
When a trader initiates a margin trade, they must set aside a certain share of their order value, a margin, to create the leverage, which is the ratio of their borrowed funds and their margin. For instance, to open a $1,000 margin trade with a 10:1 leverage, a user would need to commit their own $100.
This is just one potential scenario, a simple illustration of the mechanism. In the real world, there are many different rules and leverages offered by different markets and platforms. The margin can be as low as 2:1 (on the stock market), hover at 15:1 (for futures contracts), or go as high as 200:1 (in certain currency exchange situations). These ratios are often represented by the “x” character, and on the cryptocurrency market, the leverage typically ranges from 2x to 100x.
What is a Margin Account?
To start trading cryptocurrency on margin, you first have to create a margin account. This type of account is separate from your regular trading account, and it is used to store your collateral for the funds you borrow – in a way, it can be compared to a mortgage, that is, borrowing money from the bank to buy a house, only with a margin account, you are borrowing money from the exchange to trade at greater leverage. The advantage of this separation between your regular trading account and your margin account is that if your trading account falls short of funds as a result of a trading loss, your margin account will not be affected, so you can continue buying and selling crypto without having to replenish it. Essentially, margin accounts are a way for a trader to leverage their position and benefit from both bearish and bullish market movements. Most margin accounts come with certain minimum requirements.
What are The Advantages of Trading on Margin?
Although margin trading can potentially boost your bottom line, it does not come without certain risks. Here are some of the pros and cons of trading on margin.
– Greater purchasing power
– Opportunity to amplify your gains
– Ability to take advantage of both long and short strategies
– Potential for greater losses
– Minimum balance requirements
– Having to pay interest on borrowed funds
How to Minimize Risks?
When the exchange lets you borrow money to trade cryptocurrency on margin, it will always also set specific rules and limits to mitigate the risks. If the market ends up moving in the direction opposite to your expectations, the exchange will likely ask for more collateral to maintain your position, or it might just close it.
When this happens, you will likely get a so-called “margin call” (the notification usually arrives over email) – a situation in which, as a result of trading losses, the value of your collateral falls below the margin account minimum, and the exchange from which you’re borrowing the money for your margin trade will ask you to deposit more funds to minimize their risks.
If you can’t or won’t replenish your margin, the exchange will automatically liquidate your position – in fact; they have to do so to maintain their solvency and ensure that the only loss is the money you had in your margin account.
These risks faced by both the trader and the exchange are tangible and common. Thankfully, some strategies help address them, namely using stop-loss and take-profit orders.
Stop-loss is a common strategy for controlling the risks that acts as a safeguard to minimize the risk of losing too much on your trade. The order is placed to automatically sell your assets when a specific price is reached if your market prediction didn’t come to pass. Stop-loss can be used both in the long and short positions, and it allows you to not have to make every individual decision in difficult or unpredictable market situations.
A take-profit order is a strategy that allows traders to set the price at which they close their open position and pocket the gains. The take-profit order does not get filled unless the price of the asset rises to the set limit price. Take-profit is often used as a price bracket in conjunction with a stop-loss order, so the order is automatically filled if the asset price drops to the stop-loss level (bottom) or rises to the take-profit level (top).
These two strategies are designed to limit the risks and take some of the gambling element out of trading. A highly volatile market may not always be the best situation to make rational decisions, and establishing your limits in advance is a prudent way to maintain your financial standing and avoid unnecessary risks. These two strategies are commonly used both in the traditional markets (stock/fiat) and in the cryptocurrency market.
Margin Trading With Cryptocurrency
Margin trading in cryptocurrency is a complex and involved process that comes with its own set of benefits and frustrations. Generally speaking, due to much higher market volatility, it is a more risky process than the same type of trading on a forex or stock exchange. To do well trading crypto on margin, a trader has to be acutely aware of the current and past market trends, has to be able to analyze the price movement charts and graphs, and have a deep and thorough understanding of both the process and their personal business goals. But when things line up just right, it is a worthy pursuit.