Imagine that you’re trading cryptocurrencies online. You’re feeling extremely confident that one of your assets is about to take off. You wish you could increase your holdings, but you want to inject new capital or exit any of your other positions. With margin trading, you can increase a single holding without having to liquidate other assets or inject more capital.
Margin trading, stated simply, is borrowing funds from a third-party, such as a brokerage or exchange, to increase an investment. While margin trading multiplies your profits, it also multiples your losses. As such, performing due diligence and mitigating risk are both crucial to protecting your assets.
In this article, we’ll explore the mechanics of margin trading, discuss a few important risk management tools, and cover some of the most popular platforms for trading digital assets on margin.
Margin Trading And Leverage
As mentioned, margin trading involves the use of borrowed money, also known as leverage. Since it’s borrowed money, leverage is a specific type of loan, one that’s used to boost your buying power for assets and currencies. Although leverage can generate impressive profits in an appreciating market, any price declines can result in disastrous losses.
There are different degrees of leverage in margin trading. You can trade at 2x leverage, or 3x, 5x, 10x, or even up to 100x. In other words, leverage multiplies the amount of money you have to invest. So if you have $10,000 in capital, margin trading at 2x leverage would allow you to purchase $20,000 worth of assets. Margin trading at 3x leverage would allow you to purchase $30,000 worth of assets, and so on.
Of course, the amount of capital you’re putting up remains the same. Naturally, that means the rest of the money you’re investing is borrowed. The borrowed funds are the leverage, also called a margin loan.
It’s no coincidence that margin trading also multiplies your profits and losses. If you’re margin trading at 5x leverage and the market increases by 3 percent, you see a 15 percent return on your initial investment. But the same principle holds in the other direction. A 3 percent drop in the market value of your asset will result in a 15 percent drop in the value of your initial investment (not including the margin loan, which you still need to repay in full).
But how exactly does this process work? How does one acquire a margin loan, and what are the terms of the deal? Let’s break down the concept of margin trading further.
The Mechanics of Margin Trading
The traditional financial system has been supporting margin trading for decades, as part of the broader derivatives market. And as digital asset markets continue to emulate conventional financial products, the practice has begun to permeate digital currency exchanges, too. There are even a few decentralized exchanges working towards blockchain-based, peer-to-peer margin trading solutions.
While standard trades occur with leverage of 1:1, margin trading gives you the ability to increase this ratio dramatically. In a traditional trading environment, if you have $10,000 worth of capital to invest, then you’re allowed to invest $10,000 into the assets of your choosing and not a penny more.
However, with margin trading, you can invest more than the amount of capital you hold. This dynamic is possible because you’re investing with funds borrowed from an exchange or brokerage, with your initial investment capital serving as collateral. It’s a loan to increase your buying power.
Just as with any other type of loan, terms and conditions apply to margin trading loans. Perhaps unsurprisingly, one of those conditions is that you must pay interest on the borrowed funds until the total balance paid back. Another requirement is that you must maintain a certain amount of equity in your account, known as a maintenance margin.
The final condition is that, if your equity falls below the maintenance margin, the exchange or brokerage that issued the loan will issue a margin call. In response to a margin call, you can deposit additional funds to keep your equity above the maintenance margin threshold. If you cannot or do not add more funds, lenders have the right to liquidate some of your assets to make sure your margin trading account remains in good standing.
A maintenance margin is the minimum amount of equity that must remain in a margin trading account. It is expressed as a percentage of the total current market value of the all the assets held.
To put it a different way, your equity is the current market value of all the assets you own, minus the margin loan borrowed from the exchange. So if you hold $28,000 worth of assets but invested $20,000 on margin, then your total equity is $8,000. In this example, your equity would be just over 28 percent of your margin account holdings.
Each platform offering margin trading accounts set maintenance margins. Before you begin margin trading, do ample research and always read all the fine print.
With cryptocurrency exchanges, the maintenance margin typically falls somewhere between 1 percent and 50 percent and depends on the leverage ratio.
A margin call is triggered when an investor's equity, as a percentage of the total market value of assets, falls below the maintenance margin rate (MMR). The formula to determine this value would be:
Current Market Value of Assets = (Margin Loan) / (1-MMR)
When these two values are equal, a margin call is triggered.
When a margin call occurs on your account, you have two options. You can act quickly to add more funds to your account, thus pushing your equity back above the maintenance margin. This scenario may not be desirable, as throwing in more money can result in further losses. And even if you want to take this option, it’s often impossible to act quickly enough on cryptocurrency markets. In extremely volatile conditions, the price might fall too quickly, thus liquidating your position before the transfer of additional collateral is confirmed on the blockchain.
The other option is to do nothing and let the exchange liquidate some or all of your assets. If you don’t add funds to your margin trading account, then your equity will remain below the maintenance margin. At that point, the exchange will automatically liquidate your position (or part of your position) to prevent the loss of borrowed funds.
With a robust lending network forming across several exchanges and brokers, margin trading is more popular than ever. Many digital currency exchanges now support margin trading with Bitcoin, Ether, and other digital assets. As we continue to explore the functionality of margin trading, the following example will act as a point of reference.
Margin Trading Example Scenario
Imagine Ether has just seen a substantial decline in market value, and you're banking on a sizeable upswing soon. However, without a considerable stash of available funds, you can't capitalize on the upside potential without selling other cryptocurrency holdings.
So, you decide you’ll invest $10,000 at 2x leverage, allowing you to purchase $20,000 worth of ETH. You’re contributing $10,000 of capital and putting in an extra $10,000, borrowed from the exchange in the form of a margin loan. This arrangement increases your leverage ratio from 1:1 to 2:1, doubling the profit potential of your investment.
Let’s assume that the exchange you’re using has a maintenance margin of 30 percent. That means your equity, the total market value of your ether minus the $10,000 of borrowed funds, must remain higher than 30 percent of the overall market value of the ether you hold.
Recall that margin trading amplifies market gains. Let’s assume that in the weeks following your margin trade, the price of ETH increases by 25 percent. As a result, your open margin position with 2x leverage produces a 50 percent increase in equity, double that of the underlying asset. Without exiting your other positions, you’ve taken advantage of a market upswing, profiting immensely in the process.
The Potential Downside of Margin Trading
It’s important to emphasize that margin trading is risky, and the famously volatile digital assets market only enforces this reality. A drop in the underlying asset price can result in significant losses, eating into your equity.
Let’s imagine that instead of the ETH price increasing 25 percent, it decreases by an additional 25 percent in the weeks following your initial margin trade. The market value of your ether falls from a cool $20,000 down to $15,000.
Since you borrowed $10,000 in the form of a margin loan, your equity is sitting at a mere $5,000. This outcome results because the loan is a fixed cost. The amount that you must repay the brokerage will not decline just because the market value of the asset you purchased does.
Accordingly, your equity drops to 33.3 percent of the overall position - your $5,000 in equity as a percentage of the $15,000 current market value of your ether. The bad news here is that you're down 50 percent on your entry point, down from $10,000 in equity to just $5,000.
The good news is that your equity is still above the 30 percent maintenance margin rate established by the exchange. It’s barely above the threshold, sitting at 33.3 percent, but it is above nonetheless. No margin calls will be issued.
But what happens if the price of ether falls again?
Let’s imagine that the price drops another 5 percent from where it sits. The total market value of all your ether drops from $15,000 to $14,250. After subtracting the margin loan of $10,000, your equity is now at $4,250. That means your equity, as a percentage of the total market value of your ether ($4,250 as a fraction of $14,250), is now just 29.8 percent.
In falling below the 30 percent maintenance margin, a margin call executes automatically. As a result, you would need to add more funds to your margin trading account. Alternatively, you could liquidate a portion of your ETH until your account is above the maintenance margin again.
Mitigating the Risks of Margin Trading
To minimize the inherent risks of margin trading, investors can also utilize several financial mechanisms.
On digital asset exchanges, stop-market and stop-limit orders can be used to mitigate potential losses. Let's take a closer look.
- Stop-Market Order: Using this approach, investors can set an automatic sale price. Once the price of an asset falls to a pre-set level (the stop price), the order executes at the current market price. While Stop-Market Orders work well on traditional markets, the extreme volatility of cryptocurrencies makes them impractical. When, for instance, Bitcoin drops 5 percent in a matter of minutes, there is no guarantee the order books are thick enough for a larger order to be settled at the desired price. The price can “drop through” the stop, and execute at a lower price, resulting in a “slippage” (the difference between Stop-Market Order price and the settlement price).
- Stop-Limit Order: Using this approach, investors set two prices: the stop price and the limit price. Once the price of an-asset falls to the stop price, the order converts to a limit order. As such, your assets will only be sold at your set limit price or better. This order type is better suited for cryptocurrency markets.
When you trade on margin, you’re technically taking a long position in the purchased asset; you believe prices will go up. As such, taking a short position in the same asset can help offset potential losses in a margin account.
To short an asset, you must first borrow the coins from an exchange or brokerage firm, which requires the use of an approved margin account. Fortunately, many digital asset exchanges support both margin trading short-selling, streamlining the risk-management process. But how exactly does short-selling work?
Under a short-selling scenario, an investor borrows a specific digital asset at a set market price. Next, they immediately sell it at market value and then repurchase it after the price falls. The originally-borrowed asset is returned, and the investor pockets the difference.
Let's discuss this approach in the context of our example scenario, with Ether dropping 25 percent in value. If an investor were to sell $20,000 of ETH short, the price decline in the margin trading account would be offset by profits accrued when the short position is closed.
Let's suppose that a trader borrows $20,000 worth of ETH to short sell at the same moment you want to buy $20,000 worth of ether with a margin trade. We can even imagine that you're buying that $20,000 of ether directly from the short seller. She's bearish so she wants to short, but you're very bullish so not only are you buying, but you're buying in with 2x leverage.
Now, recall that in this example scenario, the price of ETH rapidly falls by 25 percent. Here, the short seller can use the $20,000 in capital she's holding (the cash she acquired when she sold you the ETH she borrowed to short), to buy ether at this lower market value. She can now repurchase the same amount of ether she borrowed at a much lower price to repay the lender, and also have a good bit of capital remaining to keep as profit - in this case, $5,000.
Futures are also a well-established investment product in conventional markets. In short, futures represent an agreement to buy or sell an asset on a specific date at a predetermined price. Once two parties enter a futures contract, both sides must buy and sell at the agreed-upon price on the time specified, regardless of prevailing market prices when that moment arrives.
Although futures trading can be profitable using a long strategy, many investors use this financial tool as a form of risk management. As part of a portfolio, futures are effective at balancing out price fluctuations on investments, especially when the underlying asset is particularly volatile.
Platforms That Support Margin Trading For Digital Assets
Within the cryptocurrency ecosystem, there are several exchanges that investors can use for margin trading. In some cases, exchange users provide loans to the margin market, and in others, the exchange platform does. Here, we’ll assess some of the most popular margin trading platforms for digital assets.
Binance Margin Trading
Binance, the world’s biggest exchange, launched margin trading services in July 2019. Margin trading does not require KYC. There are 23 assets available to trade, making Binance one of the most versatile platforms. Building on its spot exchange user base, Binance became one of the largest players in margin trading in a matter of months. They recently introduced 125x leverage on Bitcoin futures, the highest among all platforms.
FTX is a new player on the margin trading market. It is a cryptocurrency derivatives exchange built by the world’s largest liquidity provider, Alameda Research. FTX has quarterly and perpetual futures on the most important cryptocurrencies, and they offer innovative derivative assets like the Dragon Index (a basket of Chinese blockchain projects), Midcap Perpetual Futures (a basket of mid-market cap altcoins), the infamous Shitcoin Perpetual Futures (a basket of small market cap altcoins), and synthetic assets like the MOVE token to trade volatility in both directions. FTX has seen a lot of interest from the trading community thanks to these derivatives, and became a top 10 player in just a few months.
Prime XBT is technically a cryptocurrency broker that lends directly to investors so that they may execute trades on margin. However, the platform only supports margin trading for 5 coins and offers 9 trading pairs. As such, Prime XBT is considered a small player in the margin trading space and isn’t widely used by those who actively day trade. Without the use of KYC, PrimeXBT offers superior privacy and also posts robust trading volumes.
The Poloniex exchange utilizes peer-to-peer (P2P) lending, allowing anyone to loan their digital assets to others for margin trades. However, because coins remain on the exchange under this arrangement, it is less secure than platforms supporting external wallets.
The Kraken cryptocurrency exchange lends directly to investors so that they may execute trades on margin. As one of the largest cryptocurrency exchanges in the world, Kraken is a reputable option for those looking to trade on margin. However, while the exchange supports 25 coins for regular trades, only 8 of them are currently eligible for margin trading.
BitMEX is a reliable option for those looking to trade cryptocurrency on margin. The platform maintains user privacy in the absence of a KYC process and generates market-leading volume. Although the platform only supports 8 coins and 13 trading pairs, these numbers are as good or better than other popular platforms. BitMEX also relies on a floating maintenance margin dependent on an investor’s position. In short, as the value of a position increases, so too does the maintenance margin.
The Future of Crypto-Asset Margin Trading
As the number of digital asset users continues to grow, the demand for financial products that mimic conventional offerings is likely to continue. For those investors looking to explore the crypto-asset class, margin trading provides an opportunity to leverage the inherent volatility of these notoriously erratic markets. However, getting involved with margin trading comes with inherent risks.
To manage this exposure, investors would be wise to explore the many risk-mitigation tools available to them. From simple mechanisms like stop-loss and stop-limit orders to short selling and futures, several instruments can help protect investors from the amplified downside of margin trading.
If executed with due diligence and sound knowledge, margin trading presents a lucrative opportunity. And as more platforms support this on margin functionality, diverse product offerings are likely to attract a growing number of lenders and borrowers. For now, it looks like the crypto-asset market will continue its mainstream ascent.
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