Margin trading involves borrowing funds from an exchange, brokerage or other third-parties to increase investment. It leverages investment and position and allows traders to make more money with limited resources using a “loan”.
Just like other markets, cryptocurrency trading requires due diligence for profitability. Several hacks exist that traders use to make it big in the industry. Crypto traders with limited capital are keen on opportunities to make more profits while trading. Margin trading gives such opportunities.
Suppose a trader wants to buy $1k worth of BTC, but they only have $200. With Margin Trading, they could leverage 5:1 and borrow $800 to buy the full $1k. They then will have to pay back the $800 borrowed plus interest accrued.
From this investment, two things may happen,
- The investment goes well, and a profit is made – All traders aim at making a profit from margin trading. This way, they will not have a problem paying back their lenders.
- The investment performs poorly leading to a loss – A loss from margin trading means that the trader’s account has no enough funds to pay back the lender. Brokers place a margin call in such a scenario.
Frequently Used Terminologies in Margin trading
Some of the most used terms in margin trading are:
Margin call – Is a demand by the lender that a trader deposits additional funds or securities (as maintenance margin) to their account as an assurance that they are in a position to pay back the loan.
Buying Power – This is the total amount invested by a trader. It includes the total amount a trader has in their account plus the amount borrowed as margin.
Maintenance Margin – The balance a trader needs to maintain in their margin account for the account to remain active. If the margin account falls below the maintenance margin, the trader will have to either deposit more funds or sell underlying assets to raise funds.
Collateral – Collateral is the margin-able assets or securities on which the lender’s loan is based. Risk is created on the securities when a trader buys on margin.
Initial Margin – This is an initial deposit a trader must put before making a margin trade. A 50% initial margin, for instance, means the investor must deposit half of the buying power in their margin account and get the remaining half from lenders.
Advantages of Margin Trading
- Increased returns – Margin trading increases the buying power of traders who have limited resources and increase their returns when the price of their holdings moves in their favour.
- Portfolio diversification – With a margin account, a trader can use shares as collateral for a loan. The loan proceeds can then be used for portfolio diversification. This method is particularly useful for traders who have a large unrealized capital gain and want it to remain that way.
- Short selling – short selling is a way of trading in which margin account owners can make profits even when coin prices fall. Experienced traders take advantage of short selling to make gains even in a declining market.
- Low-interest rates – Margin loans attract lower interest rates compared to other loans. This plus the fact that less paperwork and a low application fee are required to make margin loans more competitive.
- Flexibility – There is no pressure for repayment of margin loans as long as your accounts debt is below the minimum maintenance margin. Also, the ability to invest more with less capital creates room for market exploration and taking timely action towards market opportunities.
Risks Involved in Margin Trading
Magnified Losses – As much as the margin magnifies profits for the investor, so does it also magnify potential loss. Investing with double buying power means that the potential loss will also double if the market goes wrong.
A trader can lose more than their investment through margin trading. This further magnifies the financial and psychological risks involved in this type of cryptocurrency trading. Also, contrary to the notion that taking loans from brokers is simpler than from banks, brokers can also be as binding as banks.
Margin calls Risk – Exchanges require that traders maintain a minimum margin in their margin account at all times. If this balance goes below the minimum balance at any given time, the trader receives a margin call asking them to top up their account within a limited time. If the trader doesn’t have extra cash to maintain sufficient balance, they could be forced to sell their assets at a loss.
Assets liquidation – Brokers in margin trading have the power to initiate actions against the trader if they breach the trade agreement. The brokers have the right to liquidate your assets and recover their funds if you fail to honour a margin call.
Margin Trading Best Practices
Invest Wisely: Anyone willing to invest in margin trading should always remember the golden rule: “Margin trading amplifies both potential profits and losses”. As such, ensure you are in an excellent financial and psychological position to remain in the market if things take either route.
Incremental borrowing: Beginners should abstain from borrowing the full allowed limit. Start with a smaller amount and increase it with time as you gain experience.
Early repayment: Just like bank loans, the more you stay with a Margin loan, the higher the interest you pay. It is advisable to settle the margin earlier to avoid paying higher amounts.
Margin trading is exciting and risky at the same time. It provides great profit potential but also huge risks. This calls for financially and psychologically stable investors as well as those willing to ride on the inevitable volatility of cryptocurrency markets.
Having a basic understanding of margin trading, advantages, and risks is a great first step in the long adventure of cryptocurrency trading.