Margin trading is one of the most preferred trading methods that allow you to borrow and trade crypto that you cannot afford. But it does come with a full set of risks!
Just like other financial markets, exchanges in the crypto market are introducing new ways to allow users to increase returns on investments. Although not new, margin trading is a popular method that allows leveraging the existing capital to borrow more crypto to trade. This method can be immensely profitable, but there are a few things that margin traders must consider to avoid losing all their assets. This article dives into what margin trading is, how it works and the risks and benefits associated with it.
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What Is Margin Trading?
Source: Primexbt
Margin trading is a tool that exchanges offer to allow traders to trade bigger positions than they can buy with the capital in their account. The exchange or brokerage provides additional capital to trading accounts, amplifying their buying power.
With the ability to take bigger positions, traders can make bigger profits (and losses) with margin trading. The borrowed money is repaid after the trade, while the trader enjoys the profits of the trade in full.
Different exchanges offer different levels of margin, with some exchanges allowing positions of up to 100 times the total capital in a trading account. This is quite risky, as trades with such high leverage are often quickly liquidated, causing the trader to lose all their funds.
How Does Margin Trading Work?
In margin trading, users borrow money from the exchange to trade bigger positions. When trader Jason wants to open a margin trade, he is required to post collateral worth X% of the total order value. This collateral is often referred to as the margin.
The rest of Jason’s trade is paid for with borrowed money, or leverage. Margin trading accounts and leverage are closely related, as leverage describes the ratio of borrowed money to the amount of collateral. For example, if Jason opens a Bitcoin trade of $25,000, at a leverage of 25:1, he will need to use $1,000 of his own capital. Jason will pay a very small interest rate over the borrowed capital, which is usually paid when the position closes.
Is Margin Trading Good for Beginners?
Amplifying profits by borrowing money sounds great, and it is. Nevertheless, it is better for beginners to stay away from margin trading until they have a solid track record of profitable trading without margin, using a cash account.
Margin trading adds extra risk to trading, which new traders are often unaware of. We will dive into these risks later. With experience, traders can make an informed decision on whether margin trading is the right tool for them.
Why Is Margin Trading So Popular?
Margin trading has become a popular investment strategy for a few reasons. Firstly, it allows traders to take bigger positions. Instead of buying BTC, for example, with limited capital, traders can now afford to buy more BTC than they can afford. This is capital efficient, as you gain more exposure to the upside (or downside) with less.
Another reason for its popularity is its potential for massive profits. Because traders can hold larger positions, they are able to generate bigger returns too (in case of success), all of which they can take home. If we look back at Jason’s Bitcoin trade from earlier, a 10% rise in prices will make him $2,500, even though he only used $1,000 of his capital. That’s an ROI of 250%!
Types of Margin
In crypto, there are two margin structures: cross margin and isolated margin. In cross-margin structures, a trader uses their entire account balance to margin all open positions. This allows unrealized profits from one position to support a losing position that needs additional margin.
In an isolated margin structure, traders allocate margin specifically to a position. This mode of margining allows you to manage your risks, as only the allocated amount will be liquidated.
Also Read: Cross vs Isolated Margin
Within these margin structures, there are three types of margin requirements. First is the initial margin, which is the initial account equity required to open the position.
Second is the maintenance margin, which is the equity required to keep the position running. The maintenance margin is usually lower than the initial margin. If your equity falls below the maintenance margin, a margin call is issued.
Finally, the soft-edge margin is the equity level where positions is forcibly closed by the brokerage or exchange. This margin level is often reached in volatile markets or when traders go against a strong trend.
What Are Margin Calls?
A margin call is when a brokerage or exchange requests that a trader posts an additional margin to prevent forced liquidation of a position. Margin calls are issued when the margin account drops in value to the point that the trader may no longer have sufficient collateral to meet the broker's required margin amount or maintenance margin.
When the margin account drops below the maintenance margin requirements, the brokerage or exchange notifies the trader to deposit additional collateral or sell assets to make up for the drop in position value.
If the trader fails to do so, the position might get closed or reduced by the exchange to meet the requirement, no matter the state of the market. This could mean that you are forced to close or reduce positions right when the market finds a bottom (in the case of long position).
What Are the Risks of Margin Trading?
While margin trading can generate significant profits, it comes with a few downsides too. Unlike trading with a cash account, margin trading can cause losses that exceed your initial investment. You read that right! You can lose more money than you invested. However, with spot trading, the most you can lose is the amount of capital you've invested.
With high leverage, even a small move in price can cause margin calls or even forced liquidations. Moreover, margin trading can force you to sell positions at unfavorable times to meet the margin requirements.
The high leverage can also put additional stress on your mind, which can cause you to take emotional trading decisions. Therefore, in margin trading, traders must use proper risk management strategies and tools, such as stop-loss orders.
Ways to Manage Margin Account Risks
Margin trading is risky, but risks can be managed. Traders can remove the risk of forced liquidation altogether by having stop losses in place. These orders limit the maximum loss on a trade and allow you to keep your positions under control.
Also Read: How to Use Stop Loss and Take Profit in Trading
Moreover, margin traders should never trade bigger positions than they are comfortable managing. In our experience, when traders take positions that are oversized, emotions will get the better of them sooner than later.
Difference Between Margin Trading and Buying Stocks & Crypto
Margin traders borrow money from the brokerage or exchange to purchase stocks or crypto. This type of trading amplifies their buying power, but it also forces them to meet the margin requirements or face a margin call. Because the costs of a margin loan can pile up, traders in this market often trade on a shorter time frame than cash traders.
When your investment strategy has a longer time horizon, buying stocks or crypto with cash is the safest bet. This way, you can neither lose more than you invested nor pay interest.
Closing Thoughts
All in all, margin trading can yield great rewards to successful traders, but it can ruin the accounts of less fortunate ones. It can be a great tool to use, so long as it is used properly.
If you are confident in your trading abilities, trying out margin trading might be a great next step in your trading journey. If you do, exercise strict risk management strategies!
Writer’s Disclaimer: This article is based on my limited knowledge and experience. It has been written for educational purposes. It should not be construed as advice in any shape or form.
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