How does crypto margin trading work?

Photo - How does crypto margin trading work?

Margin trading allows you to enter a trade for a larger amount than you have on deposit. But the opportunity to increase profits comes with increased risks.

What is margin trading, and how it works

Margin trading refers to the process of trading on the market using borrowed funds. The main difference of margin trading compared to spot trading is that a trader can open a position without having to pay the full amount from their own pocket. Margin trading allows you to earn more income on profitable trades but, at the same time, increases losses in case of failures.

To enter the trade, the trader provides an initial deposit known as the margin. With leveraged trading, they invest a certain percentage of the deposit For example, to open a $10,000 position with x10 leverage, a trader needs to deposit $1,000.

The total value of a trader's deposit is known as the equity and is valued at the market value of the asset minus borrowed funds.

The price of assets changes in real time, so equity is constantly changing, either. A margin call is triggered when the equity falls below a certain required level (known as the maintenance margin). This means the trader needs to either sell part of the position or deposit more funds into the account to return the margin to the required values.

A margin call is a concept that originated on the American stock exchanges over 100 years ago. At that time, traders opened and closed positions through their broker, who could be contacted by phone. When the price changed direction, and they didn’t have enough equity to complete the transaction, the broker called the trader and demanded to increase the margin. This process became a "margin call". If refused, the trader’s order was forcibly closed.

The assets the trader holds in the account are used as collateral. If the trader fails to fulfill the margin call, the exchange sells the assets to pay off the loan. This process is called liquidation.

To reduce the risks of margin trading, we advise you to follow these rules:

1. Don't risk more than you can afford to lose. Cryptocurrency margin trading can quickly wipe out your deposit.

2. Set a Stop loss. This primary risk management tool allows you to limit losses and avoid liquidation.

3. Use a Take Profit. It will automatically close the deal (or part of it) at the specified level. The cryptocurrency market is very volatile, and often traders need more time to manually close a position at the desired levels.

Features of crypto margin trading

A distinctive feature of the cryptocurrency market is the amount of leverage. The Forex fiat currency markets have extremely low volatility, so trading without leverage is meaningless. Forex brokers usually offer x100 or x1000 leverage.

The crypto market volatility allows you to get solid profits even without borrowed funds. Therefore, a small x5 leverage is enough to turn trading into a roller coaster.

However, some crypto exchanges provide leverage up to x100 on trading.

In the Forex market or the stock exchange, a stockbroker issues a loan. There are also exchanges in the cryptocurrency markets that directly lend to users, such as Kraken. However, this often happens indirectly.

A Bitfinex trader does not take a loan from the exchange but from investors who have provided their funds for margin. They invest their money at interest. Lenders receive passive income from their funds by not participating in trading but only by providing funds for margin trading.

In conclusion, we'd like to warn inexperienced traders against the temptation to make quick money using margin trading on a crypto exchange. Even if you take out a loan for high-frequency trading (scalping), you need to be very careful with the amount of leverage and soberly assess the possible profit, considering the deposit's size. Newcomers to the market should generally avoid margin trading.