What Is Margin Trading?
In the world of finance, margin trading refers to trading on funds borrowed via your brokerage account to increase your purchasing power so that you’re able to invest more than your existing funds. Similarly, crypto margin trading allows you to invest in more crypto assets through a loan from the crypto exchange you’re trading on, which functions similarly to an online brokerage platform.
Crypto margin trading can be viewed as a form of secured lending. By starting a margin trading account on a crypto exchange offering margin trading services, you deposit money in return for the ability to borrow a larger sum, which lets you purchase more investments and buy on margin. The amount you’ve deposited forms the initial margin. Your margin is then calculated as the difference between the investment value and the loan for that investment.
A credit limit, or the maximum loan you can take, is usually set at up to 50% of the investment’s purchase price. For example, by depositing $1,000 into your margin account, you’d be able to invest up to $2,000 worth of crypto assets through your account. Do note, however, that transaction fees would have to be accounted for. Interest would also be charged for the loan, which would be added to the margin balance on a monthly basis.
Although the ability to invest more may signify higher returns, investing with borrowed money may risk racking up higher losses as well. As with home loans, the crypto asset you’ve purchased on borrowed funds becomes collateral to secure the loan. Should you decide to liquidate the crypto assets you’ve bought with the loan, the proceeds would first pay off the margin loan before you would receive any remaining amount.
How Does Margin Trading Work?
Crypto margin trading provides investors with the ability to trade beyond their existing capital for the potential of higher returns, which can be enticing to many. However, such a crypto trading strategy comes with high risks, as you’re not only incurring loan interest in the process, but the crypto asset under such investment is also collateral for the loan. While all these terms are similar to traditional loans, the biggest risk of crypto margin trading lies in its maintenance requirements and margin calls.
While a minimum margin refers to the smallest amount you need to deposit in your account to buy on margin, and the initial margin is the amount you’ve used for the trade with your own money, a maintenance margin is a minimum amount of funds you need to maintain in your account. This is based on a certain percentage of the investment made. Given the volatility of investments, this helps the crypto platform ensure you’re not taking up too much debt — i.e., an amount that’s beyond your ability to repay.
What Happens When Balance Falls Below Maintenance Margin?
If the balance in your margin account falls below the maintenance margin — especially when your investment takes a dip — you may be issued a margin call by the crypto exchange. In this case, you’ll be required to deposit more funds — or sell your existing assets in order to pare down the loan percentage and bring your account back to the minimum value required. An investor is typically given a deadline to ensure this is done, or the crypto exchange will make the decision on which crypto asset to liquidate for you (while charging you a commission for the transaction). This is possible because your asset is part of the collateral for the loan.
The volatile fluctuations of cryptocurrencies greatly increase the possibility of margin calls in crypto margin trading. This can lead to forced liquidation of assets, which may be sold at a huge loss — in addition to the transaction fees and loan interest that are incurred during crypto margin trading, which may make it increasingly difficult to break even.
For experienced investors, crypto margin trading opens up the potential for deeper investment and higher profits. However, great opportunities come with more risk, and an investor needs to be aware of all the perils of crypto margin trading before dabbling in it.
Margin Trading vs. Leveraged Trading
Although crypto margin trading and leveraged trading rely on the concept of using a loan to fund bigger investments, there are fundamental differences in their respective positions. While crypto margin trading is based on using one’s assets to acquire a loan for increased purchasing power, leveraged trading refers in broader terms to investing in bigger positions with borrowed funds (beyond your own capital). This means that crypto margin trading may simply be one way among options and futures trading to trade with leverage. Companies may also use leveraged trading to finance their operations through debt financing.
A margin is essentially an investor’s basic capital invested in the trade, whereas leverage is the borrowed capital for more trading power. These two methods have an inversely proportional relationship, in which a higher margin indicates a lower leverage ratio, and vice versa. In addition, leveraged trading is generally looking at long-term returns for minimal losses, while crypto margin trading tends to have higher returns with short-term investments in markets that are high in liquidity.