Cryptocurrency offers more than one way to make money and trading is one of the most popular methods. Nevertheless, even with trading, there are so many possible approaches, and margin trading is one of them. If you’re wondering what is margin trading, we will discuss all about it below.
Margin trading is a high-risk high-reward type of method, and for this reason, some exchanges require additional qualification requirements and stricter identification.
What is cryptocurrency margin trading?
Cryptocurrency margin trading is similar to margin trading other assets such as bonds and stocks. To begin with, the initial stake is raised by borrowing money and is typically expressed as a ratio. If you stake $10 with a 2:1 leverage it means you’re placing a $20 bet in the open market.
Nevertheless, the money you borrowed must be paid back, along with the usual fees. As a result, you need to have a gain high enough to pay the loan, the fees and ideally have some profit left for yourself.
Cryptocurrency margin trading has two basic divisions. One is the spot market margin trading in which borrowed assets need to be paid back right after the trade closes. The exchange usually handles this using a peer-to-peer lending system. This means the borrowed funds are provided by another trading entity.
If the trader notices their position is sinking, the lender can apply a margin call to make sure they get back their borrowed assets. This is called a liquidation threshold.
There are two levels of liquidation threshold – an initial margin limit to prevent traders from attempting to create position they can’t hold and a lower maintenance margin limit that triggers an immediate margin call should the trader’s position fall below zero.
Derivatives trading is the second basic division of margin trading. Derivatives are financial tools created on top of the layer of an underlying asset. The most widely used derivative is the future. Once a trader makes a margin trade in the derivative market, the underlying asset remains unmoved and opposite sides of a future contract are selected.
While there is no actual loan to pay back, the exchange needs to protect itself against the trade sinking into the negative territory. The mechanisms differ from one exchange to the other. Some choose to pay off negative balances from their insurance funds, while others take on the trade’s position in case of a margin call.
Long and short margin trading
With margin trading, you can adopt long or short positions. If a long position is taken, you can think of it as a bet the asset’s value will eventually rise. A short position is exactly the opposite meaning a bet the asset will fall in value.
Long positions are perfectly described by the “buy low, sell high” saying. Once a trader buys cryptocurrency or another asset, it holds it until the price is higher than the one it was purchased with.
With short positions, things go very differently. The trader will sell assets they don’t actually own using a financial instrument with the goal of purchasing them back once the price is much lower than the one they were sold at.
Potential rewards and risks
It’s pretty obvious by now, margin trading is quite risky as the trader must expect a large profit, at least large enough to return the originally borrowed money and related fees.
Once a margin call is issued, that’s when the true risk arrives. This can potentially make the trader lose the entire initial investment, and even more if the margin call is not issued in time before the trader goes into the negative territory. As a result, with margin trading, you can end up owing more than the initial borrowed amount.
There’s also the risk of market manipulation as a result of margin trading, something with various exchanges have already been acused of.
The short squeeze is an essential concept involved in margin trading. This happens when a cryptocurrency with multiple shorts against it position gets a series of liquidated short positions in a small time frame. This will draw other short positions into a margin call scenario, raising the price while liquidating other short positions. Before the trading day is over, the cryptocurrency will experience a huge price increase.
Whales and margin trading
If you’re not familiar with whales, you should know they are traders who own large amounts of cryptocurrencies and use their influence to strategically lower the price of certain assets in some markets with the intent of purchasing the coins and selling them once the price raises.
Wales can activate a short squeeze by building up a short position large enough to trigger a squeeze by simply releasing a chunk of these shorts. The remaining shorts will be sold in calculated phases as the price continues to rise. This will of course, artificially inflate the price of the cryptocurrency in question, allowing the whale to make huge profits.
Because margin trading is both difficult and risky, only a few exchanges offer this service. Even if they do, they usually require margin traders to prove their status of accredited investors. This makes total sense as unregulated margin trading could end up multiplying losses more than one time and endanger the liquidity of the market itself.
Even so, it’s still worth understanding how it works as that would only help you understand the market better even if you don’t plan to implicate yourself in margin trading.