Cryptocurrency investors do not only hail from the retail sector. There are many professional brokers and experienced traders that participate in the cryptocurrency markets. Therefore, there are several options available in the DeFi sector where investors can maximize their profits in a limited amount of time. Margin Trading is such an option.
In this article, we will discuss margin trading and why it is considered a highly risky trading method.
What is Margin Trading?
Margin trading is a method of investing that involves working with additional capital that has been loaned or borrowed. There are several types of trading styles, such as Day Trading, Range Trading, Momentum Trading, Breakout Trading, and others, where investors can make massive profits by cashing in on the smallest market movements.
However, to increase a massive amount of profit, the investors need to maximize their capital. This capital may not be available in the personal capacity of an investor. This is where margin trading plays an important role.
Investors can apply for a loan using margin trading platforms and invest the money to earn massive amounts of profits by increasing the size of their position. Margin trading can be used for both short and long-term trading strategies.
How does Margin Trading Work?
Margin trading may seem like a great idea at first, but when a trader borrows money from another institution or investor, they have to abide by certain rules and regulations. Margin trading is heavily conditional, and the investors will increase their obligations of conducting a trade when they are using this option.
The first and most common condition of margin trading is setting up a collateral account. This account is like a warranty for the lenders to make sure that the borrower is not going to default on their payments.
The second most important risk attached to margin trading is the interest percentage. When a person borrows money or other assets for investment, they are required to pay a percentage of interest.
This interest percentage can be set at a fixed or variable rate, and it keeps increasing concerning the duration of the loaning period. For example, if a person borrows money for trading for 5 months, they are bound to pay 5% or greater interest on the total amount which is due every month.
In case the borrower fails to pay back the monthly payable with interest, they can incur greater interest as a penalty. At the same time, the borrower must make sure that the agreed value of the collateral is always present during the margin trading period.
Origin of Margin Trading
The history of margin trading is not very accurate. In the past, some sailors and statesmen presented proposals to the Monarchy or wealthy merchants to make excavations to foreign lands in search of new colonies. However, they can be classified as sponsored journeys in some cases.
However, in the United States, when banks started to gain popularity among the masses in the 20th Century, margin trading was introduced. But in its initial form margin trading was subject to exponential market risks and a lack of governing terms.
Therefore, the frequency of Margin Calls was very high, and leverage sometimes reached as big as 90%. This problem persisted until the economic meltdown of 1929, after which regulators imposed better rules in place to protect investors and lenders.
In DeFi, margin trading was introduced with the platforms like PrimeXBT. Today, just about every major cryptocurrency exchange, liquidity pool, Automated Market Maker, and arbitrageur offers margin trading options.
Important Terminologies Associated with Margin Trading
When learning about margin trading, investors can come across very complicated seeming terminologies.
However, once they get familiar with these concepts, they can learn more about this strategy and become more proficient. Here are some important margin trading terminologies for the benefit of investors:
Leverage is the total amount of funds that investors have borrowed from a cryptocurrency exchange or a private financial firm. Many cryptocurrency platforms allow users to borrow funds from other investors in a peer-to-peer manner.
Investors can use this leverage to multiply the size of their investing position by a specified ratio. For example, Bybit allows its borrowers to get a leverage ratio range of 1-100 times. The investors have the option to adjust the ratio based on their personal needs. Investors are also under an obligation to procure a collateral account to qualify for the leverage grant.
The initial margin is the amount that the investors need to open a margin trading position. For example, if a person wishes to open a position of $50 for margin trading, they will need 10x leverage, making their position $500.
Therefore, Initial Margin depends on the strength of leverage availed by the investors. As leverage grows higher, the margin grows smaller.
Collateral is a safeguard amount like a mortgage that is reserved with the lender to make sure that the borrower is not going to default on their position. In case the borrower goes AWOL or suffers from losses in their margin trading endeavors, the borrower can make up for their losses by taking ownership of the collateral amount.
At the same time, the borrower must always maintain the required value of their collateral account at all times.
In case the collateral account contains cryptocurrencies and the value of the collateral account declines due to the spot price changes, the lender can suspend the margin trading account of the investor until they refill the required amount of collateral. This event is called a margin call.
When investors borrow any amount of money or cryptocurrency from the lender for margin trading, they not only have to take care of the collateral amount. Another additional payment the borrowers are bound to take care of is the interest applied.
The lender is entitled to earn a specified amount of interest on the lump sum or installment payments of the loan amount. The interest is levied on the borrowed amount at regular intervals, and it can be either fixed or variable.
Long and Short Positions
Long positions are trades where the investors are hoping to make profits by selling or increase in the prices of their acquired assets.
On the other hand, shorting is a type of trading where investors can succeed by decreasing the price of their targeted assets or by purchasing.
Order cost is the total amount of margin that is required to open a margin trading position when creating a new long or short position. The investors cannot open the new margin position on the platform if their total investment capital falls short of the required order cost on certain platforms.
The Maintenance Margin is the total amount of collateral value that the borrowers have to maintain at all times throughout their margin trading duration. If the Maintenance Margins fall short, the lender can halt the trade until the borrower replenishes the required value.
The margin trading position can remain open until the margin call is triggered on account of the lapse of the Maintenance Margin.
Risk limit is a metric that can be used by lenders to understand the various requirements and obligations before opening a new margin trading position.
This metric tells the investors about three important requirements, namely maintenance margin, maximum leverage, and initial margin. It is also used to decrease the probability of premature liquidity for big-margin positions.
It is much like Risk Limit, but it is used for USDT contracts. Using Tiered Margin, investors can calculate the associated obligations. As the size of the margin trading position increases, the ratio of the Initial Margin and Maintenance Margin also rises.
The main difference between Tiered Margin and Risk Limit is that the output of this metric adjusts automatically on account of market price changes, unlike Risk Limit, which needs to be changed manually.
Mark price or the estimated true value of the trading contract should never become equal to the liquidation price. In case it happens during margin trading, the investors would suffer from losses, and the entire position is going to liquidate.
Therefore, investors can use prevention measures like setting up a stop-loss to get out of their positions before encountering total loss. Some trading platforms offer mutual insurance coverage to cover the loss probability.
The bankruptcy price is the amount that denotes the total loss of all Initial Margins. This is the final price at which an already liquidated Margin Trading position is closed.
Stop-loss orders are a type of threshold that predetermines a specified price where the investor intends to exit the position automatically. By setting up a stop-loss order, the investors can prevent suffering from losses in case of a sudden or unexpected market movement.
As soon as the total value of the trading position crosses the stop-loss threshold, the trading platform exits the position on its own or alerts the investor.
There are some situations when one margin position can be used to offset or lessen the payment obligations for the other. There are some cases where the futures traders do not have to deposit collateral individually for their short and long positions.
The exchange can remove the margin requirements by calculating the maximum possible losses.
What is Margin Trading in DeFi?
Margin trading in the DeFi sector is much like in the traditional finance sector. However, rather than working with securities or fiat currencies, the investors are dealing with cryptocurrencies. Depending on the type of cryptocurrency trading forum, the investors can perform Margin Trading using options, futures, or even stablecoins.
The terms of margin trading for cryptocurrency products are much the same as in any other financial market.
However, cryptocurrencies are subject to a greater percentage of Margin Trading risks on account of the massive price volatility of digital assets. The investors not only have to worry about making profits and returning the loaned amount with additional interest.
They are also under the constant threat of losing their collateral and triggering margin calls due to rapid price changes in DeFi. However, some margin trading options in the cryptocurrency space, such as Flash Loans, save them from the trouble of collateral and also reduce the risk associated with leveraged trading.
Advantages of Margin Trading
Here are some advantages of using Margin Trading for cryptocurrency investors:
Margin trading is ideal for making big gains in a smaller duration. Investors can earn a considerable percentage of profits without having to wait for years or months to realize the benefits of investing.
On account of the nature of margin trading, it is ideal for short-term trading strategies such as day trading. However, many long-term traders also use the margin trading option after adopting the appropriate risk mitigation techniques.
Margin trading can seem like a get-rich-quick scheme, but it is a completely authentic and reliable way of making profits. However, the investors who succeed in margin trading often require considerable market insight and appropriate technical skills.
Investors who intend to take advantage of margin trading must invest their time to increase their understanding of the cryptocurrency market. So they understand all the risks associated with it and make educated decisions.
In the cryptocurrency space, there are many platforms where investors can also act as lenders rather than just borrowers. These peer-to-peer trading platforms offer the chance for investors to earn interest by lending their cryptocurrency reserves and making profits without actively participating in the trading process.
Flash loans are a special type of margin trading account that does not require any type of collateral. They are specific to only the cryptocurrency market, and they are unique on account of their exponentially smaller risk.
Flash loans are based on smart contracts, and they work by completing the entire margin trade cycle in advance. The smart contract only carries out the trade if the output is as expected; otherwise, the transaction is declined, and the investors end up with their original amount.
Risks Associated with Margin Trading
When it comes to DeFi and margin trading, the combination of these two financial products is enough to overwhelm any risk management metric. Here are some important risks that investors are exposed to when they are using margin trading in DeFi:
Margin calls trigger when the investor is unable to maintain the required amount of trading balance in their account. The borrower can intervene and halt the trading account until the lender replenishes the required value.
Margin calls are more frequent in the DeFi markets because cryptocurrency prices are subject to greater price volatility. In case of any unprecedented market movements, the investors can lose their required collateral value at any given time.
Margin trading is a very risky endeavor for cryptocurrency investors. It happened because cryptocurrency prices can move in any direction at any given time. The cryptocurrency market is global therefore predicting the next market move is often very difficult, even for trained professionals.
At the same time, the price changes in the cryptocurrency market are much bigger in comparison to other investment products such as forex or stocks.
Some cryptocurrency exchanges automatically liquidate the margin trading position of an investor to avoid losses. Therefore, investors who are not using Stop-loss orders can be in for a rude awakening when all their profits are wiped out by automated liquidation.
How to Create Margin Trading Positions?
Investors who are looking for margin trading opportunities can turn to regulated and decentralized cryptocurrency exchanges. Some of the global cryptocurrency enterprises, such as Binance, Bybit, Kraken, and KuCoin, offer margin trading options.
On the other hand, the investors can also turn to the DEXs such as GMX, dYdX, LeverJ, Mango Markets, Margin DDEX, and Perpetual Protocol. The terms and conditions of a margin trading contract can differ from one cryptocurrency platform to another.
The investors may create long or short positions when margin trading, and they can also venture into the crypto derivative, such as futures and options, under the same capacity.
Margin trading is often brushed aside on account of the heavy risk implications it carries. However, if the investors have gained enough knowledge and experience, they can try their hands at this method, starting from small leverage ratios and moving upwards from there.
It is a good idea for beginners to ensure gathering sufficient information before venturing into margin trading. However, investors who have formal training can earn big profits in a limited amount of time using margin trading techniques.