As simple as it may sound to you, but margin trading is difficult and involves considerable risks. A wrong trade can amplify your losses, but it can improve your rate of return if done correctly.
This beginner’s guide aims to help you understand the basics of margin trading and the jargons used in crypto margin trading.
Let’s dig in.
Table of Contents
What is Margin Trading?
Margin Trading refers to the process of buying and selling securities on borrowed capital to increase the rate of return. Such transactions are funded by brokers/exchanges who lend the trader cash to enter the trade. And, once the traders close or square-off their trade positions in the market, they settle the margin.
Using margin you can enter into significantly larger trade positions than you could enter with your account balance. Therefore, with a small change in the price of the asset in your favour, you will end up with huge profits.
But wait, don’t jump the gun in favour of margin trading so soon before knowing the complexities involved, which we are going to discuss in the next section.
How does Margin Trading work?
Let’s start with an example. Suppose, by analysing the market trends, you are predicting at least a 5% upwards move to $42,000 in the next two days in Bitcoin.
Therefore, you decided to go long but you can buy only 2 BTC with the amount of money you have in your account. Hence, you decided to use 50X leverage and went long on 100 BTC.
The trade performed according to your expectation and you ended up with a profit of $20,000. Buoyed by the outcome, you once again used margin to enter a trade expecting a similar return. But, the Bitcoin prices unexpectedly crashed by 10% and now you are sitting with a huge loss and have breached the minimum maintenance margin level, resulting in a margin call from the exchange.
This is how margin trading works, but what’s about margin call, let’s understand it in detail.
What is Margin Call?
In margin trading, you always need to come up with the minimum equity requirement, also known as maintenance margin. It means you need to have a certain level of cash or securities in your account at all times. The maintenance margin acts as collateral, so in the event of loss in trade position, the exchange can use it to cover the loss.
However, before the exchange can use the maintenance margin, a margin call is triggered, where it asks the trader to deposit funds into the account to meet the minimum margin requirement. In failure to do so, the exchange will use the maintenance margin to cover the loss. It’s not an ideal situation for any trader and hampers their trading abilities.
In the cryptosphere, due to the robust risk management system and framework in place, exchanges liquidate position automatically as and when it breaches the maintenance margin to protect from further losses.
The Relationship Between Margin and Leverage
Margin and leverage are the two most used terms in margin trading and you need to understand the difference and relationship between the two terms.
Both margin and leverage are considered similar, but they are not.
Margin refers to the debt and is expressed in percentage, whereas, leverage refers to the taking on debt and is expressed in a ratio.
In other words, the margin is used to create leverage. For example, on a 2% margin requirement, the leverage ratio is 50:1 and on a 3% margin requirement, the leverage ratio is 33:1. Leverage always has an inverse relationship with margin. The following table shows the leverage ratio depending on the margin requirement.
When a trader opens a leveraged position, they need to put up as a fraction of the position as margin, which is also known as the required margin. For example, on a 5% margin, the maximum leverage will be 20X and on a $100,000 position, the margin requirement will be $5,000.
Risks in Margin Trading?
Risk of huge losses: In margin trading, the risk of losing more than you have invested or the initial margin is the highest. As the positions are highly leveraged in margin trading, a small change in price against the trade can lead to massive losses. For example, on 20X leverage in your trade position, the risk of loss also increased by the factor of 20.
Risk of liquidation: Exchanges constantly monitor all your margin positions and when the MTM (mark-to-market) loss exceeds a certain threshold, you are asked to provide additional margin. If the margin is not sufficient, the exchange keeps the right to liquidate your trade positions to limit losses and use the maintenance margin to recover the losses.
Minimum balance maintenance: You are required to maintain the minimum margin at all times, and failure to do so results in forced selling of trade positions, irrespective of the market trends. You may lose the chance to recoup your losses if the market conditions improve following forced liquidation.
The Safe Margin Trading Practices
Know the margin requirement before placing the trades
Use stop-loss and trailing stop-loss orders to limit the risk of loss and avoid a margin call
Scale in trading positions gradually, rather than entering all at once
Know your requirements from the specific trades, if the trade objectives are met, exit the trade position soon
Invest wisely and invest the sum you could afford to lose
Go for a lower leverage level on all your trades as every increase in leverage, proportionately increases the risk of loss
Go for short term trades when using margin to avoid paying interest and reduce the risk of uncertainty in the market, which can affect your trade positions
Is Margin Trading Suitable for You?
To many, margin trading looks like an attractive proposition to make quick money in the market, but the risks far outweigh the benefits. Certainly, margin trading is not for everyone, especially beginners. And, if you don’t know the tricks of the trade, the chances of losing more money is higher than you invested.
If you are planning to start trade on margin, first check your trading strategy on a demo account and its effectiveness. Proceed only when you are confident about the success of the trading strategy following all the safe practices to minimise the risk of loss.
P.S: KuberVerse is an educational initiative. Anything expressed here directly or indirectly is not investment advice. And we ask you to do your own research before investing.