Margin trading is a technique of trading assets using funds provided by a third party. When compared to everyday trading accounts, margin accounts enable traders to get right of entry to greater sums of capital, allowing them to leverage their positions. Essentially, margin trading amplifies trading outcomes so that traders are able to make more profits on successful trades. This ability to expand trading results makes margin trading especially popular in low-volatility markets, particularly the worldwide Forex market. Still, margin trading is also used in stock, commodity, and cryptocurrency markets.
In regular markets, the borrowed funds are usually provided by an investment broker. In cryptocurrency trading, however, funds are often provided by other traders, who earn interest primarily based on market demand for margin funds. Although less common, some cryptocurrency exchanges also grant margin funds to their users.
How does margin trading work?
When a margin trade is initiated, the trader will be required to commit a proportion of the whole order value. This initial investment is known as the margin, and it is carefully related to the concept of leverage. In other words, margin trading accounts are used to create leveraged trading, and the leverage describes the ratio of borrowed money to the margin. For example, to open a $100,000 exchange at a leverage of 10:1, a trader would want to commit $10,000 of their capital.
Naturally, different trading platforms and markets provide a unique set of guidelines and leverage rates. In the stock market, for example, 2:1 is a normal ratio, whilst futures contracts are regularly traded at a 15:1 leverage. In regards to Forex brokerages, margin trades are often leveraged at a 50:1 ratio, however 100:1 and 200:1 are also used in some cases. When it comes to cryptocurrency markets, the ratios are usually ranging from 2:1 to 100:1, and the trading community regularly makes use of the ‘x’ terminology (2x, 5x, 10x, 50x, and so forth).
Margin trading can be used to open each long and short positions. A long position reflects an assumption that the fee of the asset will go up, whilst a short position displays the opposite. While the margin position is open, the trader’s assets act as collateral for the borrowed funds. This is quintessential for merchants to understand, as most brokerages reserve the right to force the sale of these assets in case the market moves against their position (above or beneath a particular threshold).
For instance, if a dealer opens a long leveraged position, they could be margin known as when the price drops significantly. A margin call takes place when a dealer is required to credit extra money into their margin account in order to attain the smallest margin buying and selling requirements. If the dealer fails to do so, their holdings are routinely liquidated to cover their losses. Typically, this takes place when the whole value of all of the equities in a margin account, also known as the liquidation margin, drops beneath the total margin requirements of that specific exchange or broker.
Advantages and disadvantages
The most obvious advantage of margin trading is the fact that it can result in large earnings due to the increased relative price of the trading positions. Other than that, margin trading can be beneficial for diversification, as traders can open various positions with quite small amounts of investment capital. Finally, having a margin account may also make it less difficult for traders to open positions fast without having to shift large sums of money to their accounts.
For all its upsides, margin trading does have the obvious downside of increasing losses in the same way that it can enlarge gains. Unlike everyday spot trading, margin trading introduces the possibility of losses that exceed a trader’s preliminary funding and, as such, is considered a high-risk trading method. Depending on the quantity of leverage involved in a trade, even a small drop in the market rate might result to huge losses for traders. For this reason, it is vital that traders who decide to utilize margin trading employ proper risk management techniques and make use of risk mitigation tools, such as stop-limit orders.
Margin trading in cryptocurrency markets
Trading on margin is inherently riskier than normal trading, however when it comes to cryptocurrencies, the risks are even higher. Owing to the high levels of volatility, typical to these markets, cryptocurrency margin traders should be very careful. While hedging and risk management techniques may come in handy, margin trading is certainly not suitable for beginners.
Being able to analyze charts, identify trends, and determine entry and exit points won’t remove the dangers associated with margin trading, however it may help to better anticipate risks and trade more effectively. So before leveraging their cryptocurrency trades, customers are encouraged first to get a keen understanding of technical evaluation and to accumulate an extensive spot trading experience.
Margin funding
For investors who do not have the risk tolerance to engage in margin trading themselves, there is another way to profit from the leveraged trading methods. Some trading platforms and cryptocurrency exchanges provide a feature known as margin funding, where users can commit their money to fund the margin trades of other users.
Usually, the system follows unique terms and yields dynamic interest rates. If a dealer accepts the terms and takes the offer, the funds’ issuer is entitled to reimbursement of the loan with the agreed-upon interest. Although the mechanisms may range from exchange to exchange, the dangers of providing margin funds are pretty low, owing to the reality that leveraged positions can be forcibly liquidated to forestall immoderate losses. Still, margin funding requires customers to preserve their cash in the exchange wallet. So, it is vital to think about the dangers associated with it and to apprehend how the feature works on their exchange of choice.
Closing thoughts
Certainly, margin trading is a beneficial tool for those who are looking forward to increase the earnings of their profitable trades. If used properly, the leveraged trading provided via margin accounts can aid in both profitability and portfolio diversification.
As mentioned, however, this technique of trading can additionally amplify losses and involves much higher risks. So, it ought to only be used by highly skilled traders. As it relates to cryptocurrency, margin trading ought to be approached even more cautiously due to the increased levels of market volatility.