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Cryptocurrency margin trading explained

Jul 27, 2020

What is margin trading

Margin trading is a transaction with financial assets, which involves the use of borrowed funds provided by a broker in the stock or cryptocurrency market or a forex dealer. In practice, this means that a trader can use more money than he has.

Another term for margin trading is leverage trading. Leverage is defined as the ratio of a trader’s own deposit to the amount of the working lot. To obtain this type of lending, the trader’s account must also have its own funds. The minimum initial deposit depends on the requirements of a particular broker.

Margin on exchange markets is collateral that is blocked by a broker on a trader’s account when a position is opened. Margin is usually expressed as a percentage, showing what proportion of equity is required to open a position on a particular financial instrument.

For example, a margin requirement of 30% means that it is possible to open a transaction if a trader has ⅓ of the total value of the position on the account.

How does it work

The main concept in margin trading is leverage – the ratio of a user’s funds to borrowed funds.

If a trader has 500 USD in their account and a broker is ready to provide them with a leverage of 1:2, then the trader can open a position at 1000 USD.

At the same time, the trader must be aware that if the price of the asset falls by 50% in the opposite direction it will wipe him out. The same principle also works on the flip side: if the asset rises by 50% it will double the balance of the trader’s account.

Let’s consider an example to understand how it works:

Imagine you bought 10 Ethereum. The calculations for the transaction may look like this:

May 1, 2020 Purchase of 10 ETH at a price of 539 USD.
The amount of the transaction was 5390 USD.
May 6, 2020 Sale of 10 Ethereum at a price of 550 USD; transaction amount – 5,500 USD.
Your financial result – a profit of 110 USD

Now suppose that you buy the same cryptocurrency, but use a leverage of 1:5, which allows you to buy 5 times more:

May 1, 2020 Purchase of 50 coins of Ether at a price of 539 USD. The amount of the transaction is 26,950 USD.
May 6, 2020 Sale of 50 coins at a price of 550 USD. The amount of the transaction is 27,500 USD.
Your financial result – a profit of 550 USD.
The leverage helped you earn almost 5 times more. All you need to do is to pay a fee to the broker for the provided leverage and taxes.

What if the price goes down

Trading with borrowed funds is a rather risky activity. Therefore, it is necessary to understand what can happen if things don’t play out according to your plan.

If the price of the cryptocurrency purchased with a margin loan does not go in the direction that the trader expected, or if the value of other instruments from their portfolio drops, the account balance may decrease too much to sustain their open positions. Then the broker will send a so-called margin call to the client.

A margin call is a warning from a broker notifying the client that they do not have enough funds to open new positions and maintain current ones. The trader must deposit funds to the account to continue.

If the client is sure that the market situation will change soon, then he may ignore the margin call for a period of time. However if the assets continue to decrease in value, the broker will automatically close the trader’s positions and sell the asset at the current market price. This will allow the broker to fully repay the loan given to the investor.

At the same time, the amount returned to the creditor fully includes the margin – the trader’s funds that he provided as collateral. Thus, the trader loses his own money too.

The benefits and risks of margin trading

The benefits of margin trading for a trader are as follows:

You can open positions larger than those you could using only your own funds.
Traders can speculate not only when the price grows, but also when it goes down by opening short positions.
You can potentially make a bigger profit by opening positions of larger volume.

Along with its benefits, margin trading carries certain risks. The large margin that a broker provides to a trader can result in big profits but also big losses. The higher the ratio of leverage to equity – the more expensive each price point. This is beneficial in cases where the trader’s forecast is correct and the price moves in the right direction. Otherwise, the trader will incur a loss and losses get steep quick on a margin.

A few tips for beginners

For players who want to try their hand at margin trading, here are a few general recommendations:

Start with small loans. Taking a loan at a coefficient of 1:10 means that you can lose 10x what you put in. Start small and try at a ratio of 1: 2, only increasing your risks by half.
Determine the amount that you can lose without significantly hurting your financial situation, and take loans no more than 10-30% of this amount. If a trader can afford to lose $1000, then they should deposit $1000 in their account and take loans for $100-300.
Choose cryptocurrencies you’re familiar with. You should not start with currency you aren’t familiar with. You should start trading a currency initially without leverage to understand how it behaves in the market, what ensures its value and what factors determine its price. As soon as you understand how it behaves you can start margin trading.
If you take out a loan, do it strategically. You want to be calculated in your margin trading. For example, if a currency is experiencing rapid growth or there’s been some good news released about a project, then you should look into getting in on the price action.
You can close out of a bad transaction yourself without waiting for the moment of liquidation. This way you will lose only a part of the margin (professionals try not to experience more than 20% loss). Use “Stop Loss” orders, which let you limit trading risks and automatically close transactions as soon as a certain price level is reached.

The best exchanges for margin trading

The most popular crypto exchanges for margin trading include:

Bitmex – 8 cryptocurrencies, easy leverage change, minimum trade – $1, multiplier – up to x100, AutoDeleveraging verification is not needed;
Binance – trading with leverage only for verified users, six cryptocurrencies in several variants of trading pairs, the maximum multiplier is x3, a separate margin account;
Gate.io – minimum transaction is $100, verification is needed, maximum leverage – 3x, 30+ supported cryptocurrencies;
Bitmax – 3x, 5x or 10x leverage, verification is optional, margin account, a wide rage of trading pairs;
Bitfinex – several types of orders, leverage is up to 3.3x, initial margin should be at least 30% of the transaction;
Kraken – 8 cryptocurrencies, leverage is up to 5x;
Poloniex – 20+ cryptocurrencies, mandatory verification, leverage is up to 2.5x;
Huobi – a lot of trading pairs, only futures contracts, the minimum transaction price is $100, leverage is up to 5x;

Conclusion

Margin trading allows traders to potentially to make larger profits on smaller amounts of money. At the same time, along with bigger potential profits, potential losses are also multiplied. The possibility of making huge profits can lead inexperienced traders to make foolish decisions. Before trying trading with leverage, you should pay special attention to money management issues. It is necessary to limit the amount of risk in each transaction (for example, by using stop loss orders).

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