Whether you are experienced in trading conventional investments or completely new to the idea of buying and selling assets for profit, learning about margin trading in cryptocurrency can provide you with significant benefits.
There are plenty of reasons for that. But perhaps the most remarkable advantage comes in the form of being able to make trades that go beyond your current account balance.
That’s correct. With margin trading, you are able to buy and sell cryptocurrencies even without having sufficient funds in your trading account. This unlocks doors to plenty of opportunities, which are otherwise out of your reach.
To learn how margin trading works in crypto and how you can benefit from it, here’s all you need to know about this popular mechanism.
What is Margin Trading and How Does It Work?
The mechanism takes its name from the term “margin”, which refers to an amount specifically borrowed to purchase assets.
This amount is usually financed or powered by cryptocurrency exchanges or brokerage firms, which support traders on specific terms and conditions. This mechanism allows these lenders to make a profit out of executed trades.
When margin trading is applied to cryptocurrency, it means that you are getting your digital asset trades financed by a third-party lender such as a crypto exchange.
These investors cover a percentage of your intended investment, with the rest being paid by your own account. This way, you can buy a larger amount of crypto assets than allowed by your current finances. This is also referred to as using “leverage,” which refers to the portion of the trade being financed through margin.
Whenever a cryptocurrency brokerage firm, exchange, or investor lends you margin, it is tied to an interest rate as well as any assets that you have available in your trading account. This makes margin similar to a collateralized loan, where your existing cryptocurrencies are considered a type of security against the financing amount.
What Are the Benefits of Margin Trading?
Due to the way it is designed, margin trading brings several benefits to the table. Some of them stay consistent, while others fluctuate with market conditions. However, all of these advantages do provide you with a boost in your trading activity.
Make Bigger Trades and Larger Profits
Using margin trading allows you to open positions that use higher amounts than your current account balance. Apart from making way for larger trades, this also gives you the opportunity to benefit from bigger profits.
For instance, if you are trading on a bull market and expect prices to rise within a short time, you can use margin trading to amplify your position.
If you only have an account balance of $1,000 but want to make a bigger trade, you can use a leverage of 5x to open a $5,000 position through margin. The excess amount is covered by your margin account or the collateralized assets within it.
If you end up making a 10 percent profit, it will not be $100 from your original account balance of $1,000. Instead, it will be $500 due to the $5,000 you were able to use through margin. This amplification of profits lets you hit it big with favorable market conditions. Even when taking margin fees into account, this leaves with a significant chunk of profits.
Protect Your Existing Assets
Another advantage of margin trading comes in the form of protecting your previous investments. Instead of liquidating your cryptocurrency reserves just so you can make a trade, you can use them as collateral to get your required financing. Once your trade is complete, you can return the margin and free your cryptocurrencies from being held as collateral.
This makes sure that you don’t have to lose your assets especially when you are trying to HODL for the long haul. Not having to make your cryptocurrencies liquid also saves you from the extensive conversion and trading fees that you pay for the action. Instead, depending upon your margin position duration, you can pay interest and trading fees that are much lower than those charges combined.
This keeps your existing cryptocurrency investments intact while also giving you the opportunity to make some much needed profits through new trades. Unless you go through third-party lenders for specialized loans, margin trading is the only way to use your existing assets for trading. In any case, it is perhaps the easiest way to utilize your digital assets.
Make Multiple Trades in a Short Time Frame
Margin trading enables you to make multiple trades in a short time frame and help you increase your chances of gain. The excess money that you have now is what you can apply to more trades. Of course, you must be careful to select your positions wisely as the trend might turn against you and you can find yourself in a distraught situation.
Take the time to analyze your potential trades and understand why they make the most sense. You want to take a moment and confirm your thesis or be as certain as possible. The idea here is to enter positions at the right time and exit them at the right time by preparing early and minimizing potential risks.
That is why it is best to set up more narrow timeframes so that you are able to ride the trend forward without taking on more risk than you should. Practice makes perfect so you will see improvements over time if you pay close attention.
How Can You Use Margin Trading?
Since margin trading involves a heavy lending mechanism, it is only offered by select cryptocurrency exchanges. With that being said, even this limitation gives you a large pool of options to choose from.
It’s because nearly every reputable cryptocurrency exchange allows you to benefit from margin trading. These institutions mitigate their risk by following the conventional structure of margin trading, which is to only offer this solution to choice traders.
In order to avail margin from any crypto exchange, you need to have a margin account in place. This account is completely different from your usual trading account and requires know your customer (KYC) and other necessary processes to get completed. As mentioned above, it also needs a collateral balance that uses your existing crypto or fiat funds.
Once you have opened your account, you can choose from several leverage options to finance your trades. Some exchanges offer up to 3x margin, which means you only need to pay for a third of the position you want to open. Whereas, some other exchanges go even beyond that and provide you with a leverage of 5x or 10x. Some future trading platforms also offer leverage of up to 100x.
You can use margin trading by utilizing specific cryptocurrencies that the exchange accepts as collateral. Some crypto exchanges only allow you to use margin trading with the same cryptocurrencies that you are using as collateral, whereas others have no restrictions on this mechanism.
Margin Trading Can Be Risky
Similar to other cryptocurrency and even conventional trading mechanisms, margin trading comes with its own set of risks. These risks include higher interest expenses, market uncertainty, risk of losing the principal put up for collateral. The core issue with margin is that it can amplify gains and losses. As such, it is a two edged sword. Tapping into financial leverage is great if everything is going in your favor but it is an accursed sword if the position moves against you.
Let’s take a look at a few of these risks.
Higher Interest Rates
Margin loans are not free money and it is certainly not for everyone to use due to the risks involved in the scenario. Margin borrowing will carry different interest rates and varying cash or equity value requirements. Entities will also cap the amount that you can borrow at a specific percentage with regard to your total equity value. For instance if you have $5,000, they might state that you can borrow upto $2,500.
The larger your account balance, the higher the chances that you must pay lower interest rates. But that is something that will vary from entity to entity. It is your best interest to find out the different requirements and interest rates if you choose to use margin. Professionals would advise you to minimize your reliance on margin.
Market uncertainty is one of the biggest risks that you face within the world of investments when utilizing margin. The fact is that taking on margin will add another layer of risk to your portfolio because you are using borrowed money to invest. If the market goes up, you are fine, if it goes down, you still must pay the borrowed money back.
The higher the margin, the more risk you take on and the hairier the situation gets if the market goes into a downward trend. Further, the platform or exchange can modify its maintenance requirements to adjust for overall risk in many cases.
In many cases, when your equity value drops, the more you will have to add to your account to maintain the margin. Those that can not maintain the balance will be asked to hand over the collateral that they do have to meet the demands of the market. That is why you have to be certain about the opportunity to create gains and take advantage of margin.
Risk of Losing Your Collateral Funds
One can build and keep on building on top of their initial funds if they make the right calls. If they make the wrong calls, it can mean loss of initial funds/assets as well. Market downturns such as the one that happened in the cryptocurrency markets, or the equity markets during financial crises can be a large problem. Again, it is a two edged sword that can provide opportunities or slice your portfolio value.
Exchanges That Offer Margin Trading
There are several popular entities that offer margin trading in the cryptocurrency world.
- Bybit ( Over 100X)
- Binance (Many gravitate to this option)
- Deribit (Open for 50+ countries)
- BitMex (Open to several countries excluding the United States)
Points to Keep in Mind to Get the Most Out of Margin Trading
Traders might have the opportunity to take advantage of tax benefits of margin trading as well. Different countries offer varying tax incentives that let people deduct their interest expenses on their taxes. The deduction of taxes spurs people to invest and find tax rewards from the government for doing so effectively.
Study the Markets
Professions would advise beginners to stay away from using margin in the early stages of the investing and speculation journey. They would scream to stay away from that in the cryptocurrency market.
Why would they be so adamant in this regard?
They don’t want to hold you back. No, these professionals understand the risks involved in highly volatile markets and have seen what happens when the market goes against them. The pain of the reversal is amplified and so they would advise you to study as much as possible and enter the markets when you feel comfortable doing so.
Studying the current and past moves in the market will help in several ways. You can begin to recognize patterns that took place in the past and use them in the present. Then, you can include nuances to predict how the markets can do based on the information and amplify gains with margin as they gain confidence.
Assess Your Risks
Studying the markets helps you to understand the nature of the risks and helps you from an assessment in the risks you are taking on to make a profit. One can check into how the market did over the past couple of months, current liabilities, the constraints in funds right now should the market turn. The idea here is to look at if it is feasible for you to service your position and then act accordingly.
Only Use Funds You Can Afford to Lose
Finally, do not overextend yourself in the market. That is what causes potential financial ruin. Instead, stay calm, cool, and collected. Make wise choices, stay out of setups if they seem too risky and calculate the risk to reward.
By nature, using margin can seem like you are overextending yourself because you are using borrowed money to invest. But if you have done your homework you might know something that others do not know and amplifying your gains is within your right. But always do your homework, double check your thesis, and use margin sparingly so you can continue to make trades and profit.