Margin trading is a method of trading assets using funds provided by a third party. Compared to traditional trading accounts, margin accounts allow traders to access larger sums of capital, allowing them to apply leverage to their positions. Essentially, margin trading amplifies trading results, so traders are able to make larger gains on profitable trades. This ability to increase trading results makes margin trading particularly popular in low volatility markets, especially the international Forex market. Yet, margin trading is also used in the stock, commodity, and cryptocurrency markets.
In traditional markets, borrowed funds are usually provided by an investment broker. In cryptocurrency trading, however, funds are often provided by other traders, who earn interest based on market demand for margin funds. Although less common, some cryptocurrency exchanges also provide margin funds to their users.
How does margin trading work?
When a margin trade is initiated, the trader will be required to commit a percentage of the total order value. This initial investment is known as margin, and it is closely related to the concept of leverage. In other words, margin trading accounts are used to create leveraged trades, and leverage describes the ratio of borrowed funds to margin. For example, to open a $100,000 trade with 10:1 leverage, a trader must commit $10,000 of equity.
Naturally, the available trading platforms and markets offer different rules and leverage rates. In the stock market, for example, 2:1 is a typical ratio, while futures contracts are often traded with a leverage of 15:1. When it comes to Forex brokers, margin positions frequently have a ratio of 50:1, but 100:1 and 200:1 are also used in some cases. When it comes to cryptocurrency markets, ratios typically range from 2:1 to 100:1, and the trading community often uses "x" terminology (2x, 5x, 10x, 50x, etc.).
Margin trading can be used to open long and short positions. A long position reflects a bet that the price of the asset will increase, while a short position reflects the opposite. While the margin position is open, the trader's assets serve as collateral for the borrowed funds. It is critical that traders understand this point, as most brokers reserve the right to force the sale of these assets in case the market goes against their position (above or below a certain threshold).
For example, if a trader opens a leveraged long position, they may be subject to a margin call when the price falls significantly. A margin call occurs when a trader is required to deposit more funds into their margin account in order to meet minimum margin trading requirements. If the trader does not do this, their holdings are automatically liquidated to cover their losses. This typically occurs when the total value of all assets in a margin account, also called liquidation margin, is less than the total margin requirements of that particular exchange or broker.
Advantages and disadvantages
The most obvious advantage of margin trading is that it can generate greater gains due to the greater relative value of trading positions. Additionally, margin trading can be useful for diversification because traders can open multiple positions with relatively small amounts of investment capital. Finally, having a margin account can make it easier for traders to open positions quickly without having to transfer large amounts of money into their accounts.
For all its advantages, margin trading has the obvious disadvantage of increasing losses in the same way it can increase gains. Unlike regular spot trading, margin trading presents the possibility of losses that exceed a trader's initial investment and, therefore, is considered a high-risk trading method. Depending on the amount of debt involved in a trade, even a slight drop in market price can result in substantial losses for traders. For this reason, it is important that investors who decide to use margin trading use appropriate risk management strategies and use risk mitigation tools, such as stop-limit orders.
Margin trading in cryptocurrency markets
Margin trading is naturally riskier than normal trading, but when it comes to cryptocurrencies, the risks are even higher. Given the high levels of volatility typical of these markets, crypto margin traders should be especially careful. While hedging and risk management strategies can be helpful, margin trading is definitely not suitable for beginners.
Knowing how to analyze charts, identify trends, and determine entry and exit points will not eliminate the risks of margin trading, but could help you better anticipate risks and trade more efficiently. So, before using leverage, users are recommended to first develop a thorough understanding of technical analysis and gain extensive spot trading experience.
Margin financing
For investors who do not have the risk tolerance to engage in margin trading themselves, there is another way to profit from leveraged trading methods. Some trading platforms and cryptocurrency exchanges offer a feature called margin funding, where users can commit their funds to finance other users' margin trading.
Typically, the process follows specific conditions and generates dynamic interest rates. If a trader accepts the terms and offer, the fund provider is entitled to receive repayment of the loan with the agreed interest. Although the mechanisms may differ between exchanges, the risks of providing margin funds are relatively low, as leveraged positions can be forcibly liquidated to avoid excessive losses. However, margin funding requires users to keep their funds in the exchange's wallet. It is therefore important to take into account the associated risks and understand how this functionality works on the selected exchange.
To conclude
Of course, margin trading is a useful tool for those who want to amplify the profits from their profitable trades. If used correctly, leveraged trading made possible by margin accounts can contribute to both profitability and portfolio diversification.
As mentioned, this trading method can also magnify losses and result in much higher risks. It should therefore only be used by experienced traders. When it comes to cryptocurrencies, margin trading must be approached with even more caution due to the high levels of market volatility.
Find out how to get started with our Binance margin trading guide
