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The Risks of Margin Trading, and How To Do It Properly
The volume of leveraged cryptocurrency futures trading has consistently set new highs throughout 2021. Through April, when the market was up, that meant big profits for traders. But when prices dropped back down again in the Spring, it was a different story.
Borrowing money is inherently risky no matter how talented you are, no matter how the market appears to be trending. So if you’re considering margin trading, it’s important to understand what you’re doing, and what you’re risking to do it.
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What is margin trading?
Margin trading, put simply, is trading on borrowed money.
In order to receive a loan, you first need collateral (the “margin”). Think of it like a deposit, controlled by your exchange until you repay your loan. Then, according to the rules of the exchange —or the laws of the nation in which it operates — you’ll be able to borrow some multiple of the amount of capital you’ve locked in. The ratio of what you put in versus what you take out is called leverage. For example, if your margin — your collateral — is equal to the amount of money you borrow, you’re said to be leveraged at 2x. If it’s 20%, 5x. And so on.
In order to open leveraged trades on traditional markets, traders have to interact with brokers at certain times of the day. In the cryptocurrency industry, things are much simpler. Anyone can take advantage of centralized or decentralized lending platforms, which operate 24/7 and make the process simple.
With leverage, potential profits are much greater. On the other hand, potential losses are also much greater.
How to open leveraged positions?
Margin trading positions can be divided into two categories:
- Long. A trader buys an asset in hopes of selling it at a higher price in the future;
- Short. The exact opposite. A trader borrows an asset and immediately sells it, in hopes of buying it back at a lower price in the future.
In both cases, the trader earns profit from the difference in the price of the asset at the moment of opening and closing the position. In the first case, the difference must be positive (price increase) in order to profit. In the second case, it must be negative (price decrease). You can find out more about margin trading positions in one of our previous articles.
For example, let’s say you expect Bitcoin’s value will rise in the near future. To benefit from this, you open a long position with 10x leverage and a margin of $1,000. Your position will then amount to $10,000. A 20% rise in the price of BTC will yield $2,000 in profits (minus any associated fees). The return on equity (ROE) of the position — the amount of profit versus the margin — will be 100%. Without leverage, your profit would only be $200 at an ROE of 20%.
Isolated margin and Cross-margin
A number of major crypto exchanges have two types of margin: isolated and cross-margin. In the first case, a fixed margin is allocated as collateral for a certain trading position; that is, it’s isolated from the entire balance on the trader’s margin account, and applies exclusively to one trading pair. In the second case, the margin applies to all of the trader’s positions, and the leveraged funds are counted against the total available margin balance.
The advantage of the isolated margin is that it limits the maximum loss on a trade (if there are no other limiting conditions, such as a stop loss). Cross-margin allows you to hold several positions at once, which is handy, but the risks apply to your entire wallet. Thus, if even just one position meets the liquidation conditions, all other positions are also automatically closed.
Here’s the thing: everyone likes profits, but what if the market goes in the opposite direction of what you predicted? What happens then?
Well, if your positions start to take a dive, and you’re verging on not being able to pay back your loan, your exchange will do what they need to to protect themselves. That means liquidating.
Liquidation is when an exchange automatically sells off one or several of your positions, in order to ensure that the margin is repaid in full.
Let’s come back to the example from above. Imagine that you open a long position with $1,000 and 10x leverage, but the price of Bitcoin suddenly plunges 10%. That’d put you down $1,000, the value of your margin. If BTC continues to fall you’ll dip below the margin. Now it’s no longer your money, but the exchange’s money that’s on the hook.and
This is where the liquidation mechanism comes in. Before you run out of margin, the exchange automatically closes your long position; that is, it sells the leveraged Bitcoin at market price, recouping the loan plus a liquidation fee.
The threshold at which a position will be liquidated is called the liquidation price. There is no need to calculate it manually — exchanges like BitMEX or Binance have built-in calculators to provide relevant price levels.
Another important point: the greater the leverage, the closer the liquidation price is to the market price at the time of purchasing. For this reason, it is recommended for beginners to open positions with leverage no higher than 5x.
Now, using the same example, let’s look at how liquidation would affect your balance with different types of margin.
In the case of cross-margin, the extra money in your account (in addition to the $1,000 to secure the open position) would allow the liquidation price to be “pushed back,” because that money would automatically be used to secure your position. If the liquidation price is finally met, you’d lose all funds across your margin account.
With isolated margin, the maximum loss would be limited to $1,000. With the high volatility of the crypto market, minimizing risk using isolated margin allows you to keep some trading capital even in the most unpredictable situations.
Best practices for leveraged trading
In summary, the main risks associated with margin trading are:
- Greater-than-usual losses, in proportion to the amount leveraged
- High probability of a complete loss of funds through liquidation.
- Potential for unlimited losses through short selling.
Margin trading is dangerous; it requires effective risk management. No more than 3-5% of your capital should be allocated to any given trade. However, thanks to the isolated margin at such a limit, your profit can be measured in tens of percent on a single trade.
In general, your amount of leverage should be chosen based on where you want to place your stop loss order prior to opening a position. As a reminder, this is a special kind of order that cuts off your potential losses before you get liquidated.
Finally, use isolated margin to diversify your portfolio. It allows you to trade several assets at once — Bitcoin and altcoins — by allocating small portions of your capital to different trading pairs. Then, to be extra safe, you could keep the rest of your money in stablecoins, in case of a market drawdown.
Leveraged trading is risky, especially in the volatile world of cryptocurrencies. In skillful hands, it can be incredibly profitable. But without proper training and planning, it can lead to devastating losses.
Be careful, do diligent research, follow the best practices described in this article, and never bet more than you’re willing to give up. Margin trading is exciting, but it’s no game.