Margin trading is a method of trading assets using third party funds. Compared to regular trading accounts, margin accounts allow traders to access larger amounts of capital and use leverage. Margin trading is designed to improve trading results and bring more profit from successful transactions. This greatly increases the popularity of margin trading in low volatility markets, especially the international Forex market. In addition, margin trading is used in the stock, commodity and cryptocurrency markets.
In traditional markets, borrowed funds are usually provided by an investment broker. However, when trading cryptocurrency, this is often done by other traders who earn interest on the growing market demand. The least common option is for a cryptocurrency exchange to provide margin funds to users.
How does margin trading work?
When margin trading begins, the trader must deposit a percentage of the total order value. This initial investment is called margin, and it is closely related to the concept of leverage. In other words, margin trading accounts are used to engage in leveraged trading, and leverage describes the ratio of borrowed funds to margin. For example, to open a $100,000 trade with 10:1 leverage, a trader would need to invest $10,000 of their own funds.
Different trading platforms and markets operate under different rules and leverage rates. In the stock market, for example, the typical ratio is 2:1, while futures contracts are often traded with leverage of 15:1. When it comes to Forex brokerage, margin trades are often carried out at a ratio of 50:1, but in some cases - 100:1 or 200:1. In cryptocurrency markets, this ratio typically ranges from 2:1 to 100:1 – the notation “x” is often used in the trading community (2x, 5x, 10x, 50x, etc.).
Margin trading can be used to open both long and short positions. A long position assumes that the price of an asset will rise; a short position assumes a fall. When a margin position is opened, the trader's assets act as collateral for borrowed funds. This is very important because most brokerages reserve the right to force sell these assets if the market moves against their position (above or below a certain threshold).
For example, if a trader opens a long position with leverage, a margin call may be necessary if the price falls significantly. A margin call is a requirement for a trader to deposit more funds into their margin account in order to meet the minimum margin trading requirements. If the trader fails to do this, his assets are automatically liquidated to cover losses. This typically occurs when the total value of shares in a margin account (liquidation margin) falls below the general margin requirements of the exchange or broker.
Advantages and disadvantages
The main advantage of margin trading is that it can lead to increased profits due to the relatively high cost of trading positions. In addition, it can be useful for diversification, as traders can open multiple positions with relatively small amounts of investment capital. Finally, having a margin account can make it easier for traders to quickly open positions without having to deposit large amounts of money into their accounts.
Despite the advantages, margin trading has a significant disadvantage - it increases both profits and losses. Unlike spot trading, margin trading is not immune to losses in excess of the trader's initial investment and is therefore considered a high-risk trading method. Depending on the amount of leverage, even a small drop in the market price can lead to significant losses. Therefore, it is important that margin trading investors use effective risk management strategies with appropriate tools, such as stop-limit orders.
Margin trading in cryptocurrency markets
Margin trading is inherently risky, but when it comes to cryptocurrencies, the risks are even higher. Due to the high volatility of cryptocurrency markets, traders should exercise extreme caution when trading on margin. And while hedging and risk management strategies can help, margin trading is definitely not for beginners.
Analyzing charts and trends and identifying entry and exit points will not eliminate the risks of margin trading, but they can help you better predict them and trade more effectively. Before engaging in cryptocurrency transactions, you should learn the principles of technical analysis and test yourself in spot trading.
Margin financing
Investors who are not prepared for the risks associated with margin trading can take advantage of another way to profit from trading using leverage. Some trading platforms and cryptocurrency exchanges offer margin funding, meaning users can fund margin trades of other users.
This process is typically timed and earns dynamic interest rates. If the trader agrees to the terms and accepts the offer, the sponsor is entitled to repay the loan with the agreed interest. While these mechanisms may vary by exchange, the risks of providing margin funds are relatively low, as leveraged positions can be forced to be liquidated to prevent excessive losses. However, margin funding requires users to keep their funds in an exchange wallet. Therefore, it is important to consider the risks involved and understand how this feature works on your chosen exchange.
Summary
Of course, margin trading is a useful tool for those who want to earn higher income from their trades. When used correctly, leveraged margin trading can help you increase your profits and diversify your portfolio.
But as we have already said, this trading method is associated with risks and can increase losses. Therefore, it should only be used by experienced traders. In the case of margin trading with cryptocurrency, you should be even more careful due to the high volatility of the market.
Check out our Guide to Using Margin Trading on Binance