Margin trading is a strategy that allows traders to use another party's funds to make transactions.
Margin provides users with a higher amount of capital to leverage their positions more effectively and potentially boost their profit. While it is a common strategy, it is also very risky.
Since margin is a form of loan, investors must pay interest that is accumulated monthly. Generally, the higher your balance, the lower your margin interest rate is applied. In addition, investors need to provide collateral, so the assets in their accounts act like security deposits that can be liquidated if they do not fulfill their obligations.
To start this type of trading, you need to open a margin account and meet the initial requirements of your chosen third party.
Suppose you have an initial margin requirement of 40% and want to purchase $5,000 worth of asset, then your margin would be $2,000. You could borrow the rest from the broker.
Many exchanges and brokers offer a variety of leverage, ranging from 0.25x to 100x. This can amplify potential profit, but it is crucial to understand that this type of leverage comes with much greater risk, such as capital liquidation.
What do you need to know about margin trading?
After meeting the initial margin requirements, you must also keep up with the maintenance margin requirements to keep your account running.
If you do not have the minimum account balance required, you will be forced to either sell your stocks or deposit more funds to repay your debt.
This situation is called a margin call, and it is not something you can ignore. If you ignore your broker's request, your third party can liquidate your stock or other assets without your approval because you are in debt to them.
When it comes to cryptocurrencies, many investors attempt to manage their risks by hedging their position (opening the opposing position). For example, if someone holds a lot of Ethereum, this would be considered a long position. To hedge, a leveraged short position should be placed. This way, if the price of the short position rises, investors may be able to recoup some of their initial losses.
What are the advantages of margin trading?
- Higher possible profit - when trading opportunities occur, investors can take advantage of them and invest more than they are currently able to with their own funds to increase profit.
- Flexibility - there are usually no fixed payments scheduled, as the loan has to be repaid when the asset is sold (you still have to meet the maintenance margin requirements).
- Increased purchase power - your investments are not limited by your current financial situation, and you do not have to pay in cash for all your assets.
What are the disadvantages of margin trading?
- Risk - you can never be fully sure if your investments pay off. In case they do not, you might accumulate debt from the loan.
- Potentially greater losses - if the market shifts against you and the asset's price drops, you might suffer great losses - after all, you have a loan to pay off.
- Forced liquidations - if you fail to meet your broker's requirements, they are free to sell your asset without your permission.
Margin trading is often used in short-term trades of great potential, but as with every loan, it comes with risks. It is best to carefully analyze your trading situation before deciding to start buying on margin.