Margin Trading: What Is It and How Does It Work?
If you’re new to cryptocurrency trading, it may be time to brush up on some unfamiliar terminology. One of these terms is margin trading, which refers to borrowing money to purchase more cryptocurrency than you would otherwise be able to buy with the money in your account. Let’s break down this term to understand its meaning and how it works.
Margin Trading Definition
Simply put, a cryptocurrency margin trade enables traders to borrow more money to gain purchasing power and establish positions far greater than their total balance. Margin trading in cryptocurrency is a trading activity that allows traders to get more exposure to a certain asset by borrowing funds from other dealers on an exchange or from the exchange itself. Unlike ordinary trading, in which traders use their own money to finance deals, margin trading allows traders to multiply the amount of money they may trade with.
Margin trading is also known as leverage trading since “leverage” is the degree to which a dealer may double their position. For example, a margin trader who uses 50X leverage multiplies their risk and possible profit by 50.
At first sight, margin trading appears appealing; the possibility of boosting profits by 50X would pique the interest of any trader. However, there is a disadvantage to margin trading in crypto. Using leverage to enhance your position in crypto trading increases your risk.
How Does Margin Trading Work?
In margin trading, a trader provides the exchange with a little capital in return for a large amount of capital to trade with, risking it all for the potential to make a large profit.
To margin trade, a trader must make a small deposit to create a position known as the initial margin. The trader must also maintain a certain amount of money in the account to ensure their position remains open; this is known as the maintenance margin.
Different cryptocurrency exchanges provide varying degrees of leverage. For example, some exchanges provide as much as 200X leverage, allowing traders to establish a position worth 200 times their original deposit. In contrast, others restrict leverage to 20X, 50X, or 100X.
The term used to describe leverage varies depending on the platform. For example, some exchanges will refer to 100:1 leverage as 100X leverage. However, in the crypto trading sector, leverage is commonly referred to using the latter terminology, i.e., “X.” 100X leverage is equivalent to 100:1 leverage.
In cryptocurrency markets, the ratios often range from 2:1 to 100:1, and the trading community frequently uses the ‘x’ word (5x, 20x, 100x, etc.).
Traders can open long and short positions via margin trading. A long position implies that the asset’s price will rise, while a short position implies the reverse. The trader’s assets are security for the borrowed cash while the margin position remains active or open. This is crucial for traders since most brokerages retain the right to sell these assets if the market goes against them, which could mean going above or below a defined threshold.
Why Trade On The Margins?
Margin trading enables experienced traders to open positions that are significantly more rewarding than they could ordinarily acquire. For example, a position successfully completed with 100X leverage will give 100 times the profit of a position established in regular trading.
Margin trading cryptocurrencies also enables calculated traders to benefit in a down market by taking short bets. For example, a trader who anticipates a significant price drop might devote a portion of their capital to a short position to profit from the possible loss caused by a significant price drop.
Pros of Margin Trading
The most obvious benefit of margin trading is that it can lead to higher earnings attributed to the higher relative worth of the trading positions. In addition, because leverage is readily available with a contract for differences (CFDs), you may profit not just from a rise in prices but also from a drop in prices. When you combine this with the resources to handle a vast amount of money, you’re ready for both the bear and the bull markets.
Margin trading is beneficial for diversifying assets because traders can create many positions using small amounts of their investments. Traders can diversify cryptocurrency assets as they only need to commit the margin upfront. Also, owning a margin account may allow traders to open trades swiftly without transferring significant amounts of cash to their balances.
Cons of Margin Trading
For all of its benefits, margin trading has the clear downside of raising losses in the same manner that it may raise winnings.
Margin trading involves the chance of losses that surpass a trader’s original investment and is thus regarded as a high-risk trading practice. Based on the volume of leverage used in a trade, even a minor dip in the market price might result in significant losses for traders. As a result, investors who want to use margin trading must implement suitable risk management methods and risk reduction instruments, such as stop-limit orders.
Margin calls are another disadvantage of margin trading. You will receive a margin call when your free margin falls below zero. The good news is that you may avoid margin calls by practicing effective risk management.
Because margin trading is based on a loan issued by your broker, you must pay interest if you want to maintain your position overnight. Fortunately, margin trading interest rates (financing charges) are often relatively cheap.
Margin trading is a good way to make huge profits with a relatively smaller amount; however, it is a high-risk activity that should only be carried out by veteran traders who are well familiar with the market. It can make you astronomical profits, and it could also get you rekt within minutes; always practice risk management and trade with caution.