What is Margin Trading? A Comprehensive Guide
Margin trading has been gaining popularity among crypto enthusiasts. How much do you know about it, and what is the hype about?
Here’s our most comprehensive guide for you to learn everything you need to know about what margin trading is.
Introduction to Margin Trading
Trading means buying and selling assets with the aim of making a profit. Institutional trading looks at buying and selling stock, shares, and currencies.
As we’re here for crypto, trading virtual currencies means buying and selling digital assets. Although the tradable assets differ, the purpose remains the same in both worlds. To put it differently, trading aims at one thing – getting a return on your original investment.
What is Margin?
To better understand margin trading, we need to start with the very basics.
The term margin has several meanings.
In the context of business, margin refers to the difference between the selling price and production cost of a product. However, our focus is on trading.
In the world of trading, it refers to the assets borrowed from a third party to make an investment. So, buying on margin essentially means borrowing funds to buy assets.
The History of Margin Trading
Like many other crypto trading practices, the roots of margin trading link to traditional finance. Although the concept is rather new in crypto trading, it has been around for a while in stock markets. Margin trading was common in the U.S. in the 20th century. However, the practice differed a lot from what we know today. Mainly, the difference was in regulation and requirements.
Back in the 1920s, margin requirements were very loose. Investors could commit very little funds of their own, and brokers allowed that. For instance, leverage rates of up to 90% were quite common. Seems shocking, right? Well, this leads us to the next point. Namely, high leverage rates contributed to a high number of margin calls. This became disastrous when the market fell, and, eventually, culminated in the 1929 crash.
Since then, buying on margin has changed substantially. The stock market crash graphically explained the need for a more regulated industry. So, the requirements have become much stricter. Although it is still a risky practice, many security measures are added to it. In the traditional financial markets, brokers face requirements for opening a margin account, minimum initial investments and maximum leverage rates are in place. In conclusion, margin trading has come a long way since the beginning of the 20th century.
Now that you know the history of this practice, let’s get into more detail.
What is Margin Trading in the Crypto World?
Margin trading is a practice that allows trading assets by using additional funds provided by a third party. Margin accounts give traders access to more capital. This means that traders can leverage their positions. In essence, margin trading strengthens trading positions and traders can realize larger gains on successful trades.
As mentioned above, traditional markets fund margins by using an investment broker. What about providing these funds in the crypto market? This is usually done by other traders. Their motivation is to earn interest on the funds borrowed for margins. In some cases, the exchange is the party that provides margin funds to traders.
Margin Trading – a Practical Example
Here’s a practical example.
First off, a trader needs to commit a percentage of the total order when making a margin trade. The initial funds that the trader deposits are called margin. Now, the trader will choose a leverage. In other words, the ratio of the borrowed funds. As previously mentioned, exchanges have learned from the history. There are limits to margins to keep all parties safe. The leverage limits depend on the policy of the exchange.
Now, let’s get more practical and look at a real use case. For example, a trader commits €25 as a margin. The trader then decides to leverage the trade 3x. So, the trader borrows €50 to buy €75 worth of Bitcoin. Simple, right? Yes, margin trading is not complicated yet requires caution. Regardless of the results of the trade, you need to return the borrowed funds. In this case, €50 plus the fees.
Short vs Long Positions
Now that you have learned the basics of what margin trading is, let’s get more technical. Margin trading is quite universal. This means you can use it to open short and long positions.
Traders use a short position when they predict that the market is going to move down. Basically, they are betting against an asset instead of for it.
A short position often turns a temporary decrease to the trader’s advantage and can be used with or without leverage. For example, a trader believes the crypto market is heading downwards. S/he predicts that the price of bitcoin will experience a major decline. So, the trader decides to short it by using leverage. Therefore, s/he borrows funds to amplify the trade and sells BTC. In case the predictions were correct, the market begins to decline, i.e., the price of bitcoin drops.
The trader can now use the profit s/he made from the trade to pay back the leverage and the fees and buy back more bitcoin. In conclusion, using a short position with leverage can amplify profits. However, it is important for beginners to be cautious when using a short position with margin. Make sure to do your research beforehand and understand the risks.
On the other hand, traders use a long position when they believe that the market is heading towards an increase. So, they either bet that the price of a certain asset or the entire market will continue climbing. They make profits from the price appreciation and sell at a later date.
Risks of Margin Trading
Any kind of trading involves risks since it is a financial activity. As such, it is important to know where you stand to make the right decision. As you can already guess, margin trading is riskier than regular trading. This is because traders borrow part of the funds that they invest. So, the borrowed funds need to be returned along with interest. Cryptocurrency prices can be volatile, so it is important to take some safety precautions.
Knowing the market and having technical analysis skills will not eliminate the risks completely. However, they will give you a much steadier base for margin trading. We have prepared a few tips that come in handy when trading on margin.
Understand the Terms
This is a basic but very important guideline when margin trading. Make sure that you understand the terms and conditions of the platform you are using. This includes the fees that they charge for the trades. Make sure to look for a platform that is transparent and clear in explaining their policies. You can spot this by looking at their landing page. For instance, it should mention the maximum leverage and the obligations that come with trading. If you need more information, reach out to their customer support team.
In general, you should aim to know how much you are borrowing for leverage and what are the conditions of the agreement. So, having a clear idea of your financial commitment will prepare you for margin trading.
Start Out Slow
Margin trading offers much higher potential gains than regular trading. We get it – this may seem very tempting. Just keep in mind that higher profits come with higher risk. So, consider starting out with a smaller leverage, such as 1x or 2x before going all in. It will help you get to know the margin trading market and you can gradually increase your risk. This approach decreases the chances of automatic liquidation.
Also, trading with a low leverage has more benefits. For instance, it allows traders to maintain positions for a longer time. This will make it very unlikely that a long position will be forcefully liquidated. Low leverage positions can be maintained until the true trend is revealed by the price movement.
In general, low leverage trading is a recommended entry method for beginners. It’s a great introduction to margin trading and gives newbies more breathing room compared to high-leverage positions.
Know Your ABCs
It is very helpful to know the fundamentals of crypto and margin trading before starting. This includes everything from technical analysis to trading tools. Being able to detect market signals can amplify your success by a lot. A strong foundation helps traders recognize opportunities, keep emotions out of their decisions, and mitigate losses.
So, where to start out? Learning about technical analysis is a safe bet. Technical analysis focuses on internal market events. This strategy involves studying price charts and diving into data. So, traders analyze the historic price movements of assets, upticks and decreases. Ultimately, they make trading decisions based on it.
Understanding technical analysis will certainly help you understand the market. Ultimately, it will mitigate your risks when margin trading.
Use the Help of Tools
Technical analysis can be hard to grasp at first. Especially, if you are just getting started with crypto. This is why traders need the right day trading crypto tools to help them with technical analysis. Some of the most important crypto tools are indicators.
Trading indicators help traders figure out the price direction of an asset. They are helpful in both long and short term price analysis. They signal the events that are bound to happen in the trading market. Trading indicators can measure a wide array of aspects. For example, price movement, volume, momentum and other factors.
Examples of Trading Indicators
There are tons of trading indicators available. Traders choose them based on their own preference and experience. For instance, Relative Strength Index (RSI) aims to quantify the gains and losses of an asset over a fixed period of time. RSI is quite universal. So, both beginners and pro traders tend to use it.
Moving averages are also a popular category of indicators. There are many variations of averages. The Simple Moving Average (SMA) represents the price of a cryptocurrency over time. Moving Average Convergence Divergence is used for signalling the beginning of short-term price trends and reversals.
Momentum helps crypto traders judge the strength of a price movement. So, it compares the closing prices of cryptocurrencies over time. Fibonacci Retracement takes two extremes (such as peak and trough). Then, it divides the vertical distance by the key Fibonacci ratios. So, traders can detect support and resistance levels.
These were only a few examples of some handy trading indicators. But there are many more available. You can check out our guides on trading indicators to learn more about the topic.
How to Start Margin Trading?
We have covered the basics of margin trading and how to mitigate risks. How to start margin trading?
You can start by picking an exchange – not all platforms offer margin trading. Equally important, there might be certain restrictions based on your location, and other factors.
Margin trading offers also differ from one exchange to another. That is, the maximum leverage that an exchange offers, fees as well as trading terms.
Now that you know what margin trading is, why not try it in practice? CoinMetro offers a Margin Trading platform with a 5x leverage. There are trading indicators and other handy tools available to help you with trading.