What is Margin Trading?
Margin trading is an effective means by which traders use funds provided by a third party. Compared to ordinary trading accounts, margin accounts give traders access to larger amounts of capital, which enables them to take advantage of their positions. Essentially, margin trading boosts trading results so traders can make higher profits on successful deals. This ability to widens trading results makes margin trading particularly popular markets with low volatility, especially the international Forex market. Nevertheless, margin trading is also used in cryptocurrency markets.
In traditional markets, borrowed funds are given by an investment dealer. However, in cryptocurrency transactions, funds are often backed by other traders, who earn interest based on market demand for margin funds. Some cryptocurrency exchanges, including BaseFEX, also provide margin funds to their users.
How Does Margin Trading Work?
When a margin trade is initiated, the traders will be asked to confirm a percentage of the total value of the order. This initial investment contributed by the trader, called the margin, is closely related to the concept of leverage. In other words, margin trading accounts are used to create leveraged transactions, and leverage describes the ratio of borrowed funds to margin. For instance, to open a $120,000 position with 10: 1 leverage, a trader would have to put $12,000 of his capital.
Different platforms and trading markets offer a unique set of rules and leverage rates. In the stock market, for example, the typical ratio is 2: 1, while futures are often traded at 15: 1 leverage. Margin is usually multiplied by a rate of 50: 1, but the 100: 1 and the 200: 1 case is nothing new. For cryptocurrency markets, ratios typically range from 2: 1 to 100: 1, and the commercial community often uses the terminology "x" (2x, 5x, 10x, 50x, etc.).
Margin trading is great for opening long and short positions. A long position implies the assumption that the asset price will increase, while a short position demonstrates the opposite. While the margin position is open, the trader's assets serve as collateral for the borrowed funds. Traders must understand it because most brokerages reserve the right to prompt the sale of these assets in case the market moves against their position (above or below a certain threshold).
For example, if a trader opens a long leveraged position, there may be a margin call when the price drops significantly. A margin call takes place when a trader is required to deposit more funds into its margin account to meet minimum margin trading requirements. If the trader fails to do so, his assets are automatically liquidated to cover his losses. This usually occurs when the total value of all shares in a margin account, also known as a liquidation margin, drops below the total margin requirements of that particular exchange or broker.
Pros and Cons
The most conspicuous benefit of margin trading is that it can bring about higher profits because of the greater relative value of trading positions. Apart from this, margin trading can be practical for diversification, as traders can open multiple positions with relatively low amounts of investment capital. Finally, a margin account can help traders quickly open positions without having to transfer large sums of money to their account.
Despite all its advantages, margin trading has the disadvantage of increasing losses in the same way that it can increase earnings. Unlike ordinary cash transactions, margin trading introduces the possibility of losses greater than the trader's original investment and is therefore considered a high-risk trading method. Depending on the amount of leverage involved in a transaction, even a slight decrease in the market price can lead to significant losses for traders. For this reason, it is imperative that investors who decide to use margin trading use risk management strategies.
Margin trading is intrinsically riskier than normal trading, but for cryptocurrencies, the risks are even higher. Due to the high levels of volatility typical of these markets, cryptocurrency margin traders should pay particular attention. Although hedging and risk management strategies may prove useful, margin trading is certainly not suitable for beginners.
Being able to analyze charts, identify trends, and determine entry and exit points will not eliminate margin trading risks, but it can help better anticipate risks and negotiate more effectively. Therefore, before taking advantage of their cryptocurrency transactions, it is recommended that users develop a thorough understanding of technical analysis and gain extensive experience with spot trading.
For investors who do not have the risk-averse that allows them to do margin trading themselves, there is another way to take advantage of leveraged trading methods. Some trading platforms and cryptocurrency exchanges offer a feature known as margin funding, in which users can commit their money to fund transactions of other users' margin.
Usually, the process follows specific terms and generates dynamic interest rates. If the trader accepts the terms and accepts the offer, the fund provider will receive the principal with the agreed interest. Although the mechanisms may vary from one exchange to another, the risks associated with the provision of guarantee funds are relatively low, since leveraged positions can be liquidated to avoid immoderate losses. Nevertheless, the margin funding asks users to keep their funds in the foreign exchange portfolio. It is, therefore, critical to take into account the risks involved and understand the functionality in the exchange of choices.
Without a doubt, margin trading is a handy mechanism for those looking to bolster the profits of their successful transactions. If used correctly, leverage transactions provided by margin accounts can result in both profitability and portfolio diversification.
As discussed, this trading method can also exacerbate losses and bring about much higher risks. Therefore, it should only be used by highly seasoned traders. As far as cryptocurrency is concerned, margin trading should be approached with even greater care due to the high volatility of the market.
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