Crypto Margin Trading: Everything to Know
By Beluga Research August 31, 2023
- Cryptocurrency margin trading refers to borrowing funds to amplify trading positions, enabling traders to potentially increase profits or losses
- Margin trading allows traders to control a larger position with a smaller amount of personal funds
- Many cryptocurrency exchanges offer margin trading, each with specific terms and rules
- Margin trading comes with increased risks, as losses can exceed the initial investment, and there is a potential for liquidation of positions
Cryptocurrency margin trading refers to borrowing funds to amplify trading positions, enabling traders to potentially increase profits or losses. By trading on margin, traders can control a larger position in the market with a smaller amount of personal capital. However, this also increases risk, as losses are magnified in the same way as gains. Thus, it is crucial for traders to understand the risks associated with margin trading and have a solid risk management strategy in place.
A Brief History
Margin trading has been used in traditional financial markets for a long time, dating back to the early 20th century. The practice allows traders to borrow funds to increase trading positions. With the rise of cryptocurrencies, this concept was extended to the crypto market, enabling traders to speculate on digital assets with borrowed funds. Unfortunately, the volatile nature of cryptocurrencies can make margin trading particularly risky, and inexperienced traders can find themselves facing substantial losses if not approached with caution and proper risk management.
Margin: Everything to Know
Margin trading involves borrowing funds to leverage trading positions and maximize potential profits. To begin, users deposit an initial margin as collateral for the borrowed funds, and the leverage ratio determines the ratio between the borrowed funds and the initial margin. For example, a leverage ratio of 10:1 means that for every $1 of the initial margin, the trader can hold a position worth $10.
Margin trading allows traders to amplify potential gains by controlling larger positions than available personal capital allows. However, this means that losses are also magnified. If the market moves against the trader, the losses can exceed the initial investment, resulting in "liquidation."
Users must maintain a minimum margin level to avoid automatic liquidation. The margin level is calculated by dividing the equity, or account value including unrealized profits and losses, by the used margin, or borrowed funds. If the margin level falls below the maintenance margin threshold, the position may be liquidated to repay the borrowed funds.
Liquidation involves the automatic closure of the trader's position by the exchange to repay the lender. Any remaining funds beyond the borrowed amount are returned to the trader. However, if the liquidation price exceeds the available funds due to a sharp market movement, the trader may experience a loss greater than the initial investment.
Not all cryptocurrency exchanges offer margin trading, and the availability of leverage ratios may vary. Therefore, traders should choose a reputable and secure exchange that supports margin trading and aligns with personal risk tolerance. Traders should have a thorough understanding of the market, employ effective risk mitigation strategies and only trade with funds they can afford to lose. Setting "stop-loss orders," or instructions to automatically sell a cryptocurrency asset if the price reaches a certain predetermined level, is advisable to limit potential losses.
To begin margin trading in the cryptocurrency market, a trader must first open an account on a reputable exchange that offers margin trading. The trader must then complete the registration and verification processes, including "Know Your Customer" (KYC) requirements.
After verifying the account, the trader may deposit funds into the associated exchange wallet. The amount deposited determines the trader's initial margin, which secures the borrowed funds. A review of minimum deposit requirements on the exchange should be completed prior to depositing.
Once funds are deposited, the trader may explore available trading pairs and select the desired cryptocurrency for margin trading. Not all cryptocurrencies may be available for margin trading, so the trader should perform research accordingly.
When initiating a margin trade, the trader borrows funds from the exchange's margin pool to increase their position. The borrowed funds act as leverage, allowing control of a larger position. The "leverage ratio" determines the ratio between the user's funds and the borrowed funds, typically ranging from 2:1 to 100:1.
Cryptocurrency margin trading differs from traditional methods due to the high volatility of cryptocurrencies. Prices can fluctuate rapidly, resulting in amplified profits or losses when combined with leverage.
Liquidation is a crucial concept in cryptocurrency margin trading. Traders must maintain a minimum margin level to secure the loan. If the trading position's value falls below the minimum margin requirement, the exchange may initiate liquidation and sell off the position to repay the borrowed funds.
"Margin calls" are issued when a trading position approaches the liquidation level. To avoid liquidation, the trader must add more funds to increase the margin, as failing to meet the margin call leads to automatic liquidation.
- Increased Profit Potential - Margin trading amplifies potential profits by allowing traders to open larger positions with leverage. Even small price movements can result in higher returns compared to trading with available capital.
- Diversification of Trading Strategies - Margin trading enables traders to diversify strategies. With more capital, they can explore different markets, trade multiple cryptocurrencies simultaneously and use complex techniques. This helps to spread risk and potentially increase profitability.
- Access to Short Selling - Margin trading allows traders to engage in "short selling." By borrowing and selling a cryptocurrency, traders can profit from price declines. This ability to profit in both rising and falling markets benefits experienced traders.
- Leveraged Exposure to Cryptocurrencies - Margin trading provides leveraged exposure to cryptocurrencies without the need to own the underlying assets. This is useful for capitalizing on price movements without the logistical challenges of owning and storing digital assets.
- Increased Risk of Losses - Margin trading exposes traders to greater risks, as leverage amplifies both gains and losses. If a trade goes against the trader's prediction, losses can exceed the initial investment, leading to significant financial setbacks. Thus, risk management is crucial.
- Margin Calls and Liquidation - Traders must maintain a minimum margin level to avoid margin calls and potential liquidation of positions. If the value of positions declines to a certain point, the exchange may issue a margin call, requiring additional funds or risking forced position closure. Failure to meet margin requirements in a volatile market can result in unexpected losses.
- Higher Complexity and Learning Curve - Margin trading is more complex than regular spot trading, requiring an understanding of leverage, risk management and market dynamics. Traders need to grasp concepts like "margin ratios," "maintenance margin" and "liquidation prices," meaning that novice traders may find it challenging to navigate effectively.
- Emotional Stress and Impulsive Trading - Margin trading's potential for higher profits and losses can induce emotional stress and impulsive decision-making. "Fear of Missing Out" (FOMO) or the urge to recover losses quickly can lead to hasty and irrational trading decisions. Discipline, adherence to trading strategies and avoidance of emotional impulses are essential.