Margin is using borrowed funds to execute a trade. Margin trading allows traders to increase profits.
Trading cryptocurrencies is probably one of the most popular and entertaining ways for newcomers in this space. However, it is far from risk free. Trading as such is a proper job, which needs skills, experience, education and much more.
Thus, jumping straight to the cryptocurrency world and starting trading without any previous experience is like playing a football match with professional footballers without any previous experience on the pitch.Many newcomers, unaware of what the implications of this decision are, even decide to go for margin trading in the cryptocurrency world.
While it seems very promising at the first glance, if the trader does not have experience with trading, using margin can become extremely risky. Why? To answer this very simple, yet broad question of why margin trading can be very risky, let’s first define what it is and how it works.
What is Margin?
Margin, in its simplest definition, is using borrowed money, usually directly from the broker or exchange, to trade or invest. This is usually provided by the platforms themselves, which traditionally divide the accounts into cash accounts, where the users are only able to invest or trade their money, and margin accounts, where the traders are eligible for loans from the exchange.
Margin then can be viewed as the collateral that the users deposit to the exchange or broker. This is to help offset the risk that the platform is taking by offering loans to the users, who then use them to long or short financial assets. Thus, if the users of the margin account decide to buy with the borrowed assets from the exchange, they are buying on margin or margin trading.
To put all of this into perspective, if the broker requires 60% for the opening of the margin account, and the trader wants to buy stocks worth 10,000 dollars, the initial margin, the sum put into the account, would be 6,000 dollars.
The traders or investors usually do this with one main goal in mind. To amplify their returns. Margin trading allows the traders who do not have sizable capital, to invest more money into their trades. This leverage, as it is also commonly known, can thus help increase the profits in case the price of an asset moves into the expected direction. However, this also means that if the opposite is true, the losses are also amplified by the leverage.
Margin is very popular mainly in financial markets that do not have high volatility. Due to the low volatility, the margin can ensure that the movements are earning enough profit (or loss) to make it worth trading.
When it comes to cryptocurrency markets however, the volatility is tremendous, which means that using high leverage/margin can lead to significant losses, but also gains. For instance, a 10-15% daily move, which is very common in the cryptocurrency world, with a 5:1 leverage can lead to 50-75% gain or loss depending on the trade. And that is nothing compared to margins that go as high as 100:1 or 250:1, which in the cryptocurrency world is often depicted as 100x or 250x.
Essentials phrases of margin trading
While we have shortly explained what initial margin is, there are other important concepts that are connected to margin and margin trading, which is why we briefly look at them here:
- Minimum margin – minimum margin is the lowest possible sum that the broker requires as the upfront capital inserted into the account. Usually this is 2,000 dollars or 100 % of the purchase price, whichever is less. Yet, this is solely based on the broker, which means that it can be more than 2,000 dollars, if the broker decides. The minimum was set by the Financial Industry Regulatory Authority (FINRA) regulator, which means it cannot be lower than 2,000 dollars.
- Initial margin – as was stated above, initial margin is the percentage of the purchase price that the traders are covering themselves, in their own capital, when trading on margin. While this again is connected to the brokers, the investors are allowed to borrow up to 50% of the initial purchase price.
- Maintenance margin – is the percentage of the funds that the trader needs to maintain in the margin account at all times, when margin positions are opened. Depending on the broker this amount can be 25%, at minimum, but can come higher to 30-40 %. The reason for having a maintenance fee is to discourage irresponsible trading as well as making sure that the investors do not get too much into debt, in which case the margin call follows.
- Margin call – margin call is a situation when the overall equity of the margin account is too low to meet the maintenance margin. If this happens, the broker sends a notice to the holder of the account to add more capital to the account. In case that does not happen, the broker can sell different positions held in the account without any need for approval from the account holder to cover for the loss. However, since the broker has the right to choose which positions will be closed, the traders usually fear the margin call as it can lead to closing positions at unfavourable prices.
Benefits of margin trading
Obviously, the biggest benefit and one of the main reasons why any investor or trader is looking to use margin is to increase the potential gains. The leverage allows traders to have higher purchasing power than they would have otherwise, meaning that in dollar terms they are able to make more money.
Some professional investors and traders also use these services to hedge their positions or diversify their portfolios, however, this is a more complicated topic. Other benefits of margin also include flexibility, as margin accounts do not have fixed repayment schedules. The loan only needs to be repaid back once the stock is sold, unless the maintenance margin requirements are compromised. In that case, the margin call follows.
Disadvantages of margin trading
Margin trading definitely has more disadvantages than advantages, especially for newcomers to the trading and investing world. Magnification of losses is without any doubt the main one, as the trader or investor who is on the wrong side of the trade and used a margin now suffered much higher loss then they would otherwise.
Another disadvantage is the margin calls themselves. If the value of the account sinks way too low, the investor or trader is required to input more capital into the trading account or risk closing the trades. This means that the trader or investor needs to have a capital ready on the side, just in case the market moves unfavourably for them.
This leads to another disadvantage, which is called forced liquidation. Unless the trader or investor is able to cover the losses incurred by margin trading and they receive the margin call, which they are not able to fulfil, the forced liquidation comes. This gives the broker the power to close positions on behalf of the trader and can enhance the losses incurred by margin trading.
Last but definitely not least, since margin trading is essentially taking up a loan from the broker, there are interest fees connected to it. Margin interests are usually somewhere between 5-12%, no matter how well or poorly the trader is doing. This is definitely a cost that the traders who are looking to use margin trading need to take into account.
Short selling vs margin trading
To many, margin trading can be very similar to short selling, since the user of the platform is borrowing funds from the given platform. The overall mechanics of short selling and margin trading are, however, quite different.
Short selling means borrowing shares from the given brokerage. The overall intent of short selling is to buy the shares back at a lower price. If the price then falls, the short sellers make money, since they purchase the stock at lower prices. Yet, if it does not and the stock goes up, the traders lose money, which in this case can be theoretically unlimited, as the stock can rise to “infinity.”
That is the main reason why short selling can be considered even riskier than margin trading. With margin trading, the tradera do not risk losing more than they invested and borrowed. With short selling, if the stock that was being shorted keeps rising, the trader would receive margin calls over and over again.
While margin trading is very popular amongst cryptocurrency traders that does not mean that the traders are using it right. Trading on its own is very difficult, adding more leverage and borrowed assets to it brings the overall risk level even higher. With that being said, the investors and traders who are experienced, have proper risk and money management can benefit from using these tools to their advantage and increasing the dollar-denominated profits.
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