When venturing into crypto trading, individuals may see high potential for high returns in instances that require more startup capital than they may have. In such cases, one can borrow money from a broker or other entity to gain more capital for their investment plan.
The sum one invests in, including the collateral provided, is known as a margin and generates a degree of trading power known as leverage. Margin trading can generate leverage, which in turn amplifies both profits and losses.
So, what exactly is the difference between the two?
Margin trading is mainly based on the performance speculation of an asset. One can further capitalize on the future price movements of an underlying asset hinged on borrowed funds.
One’s portfolio holdings are collateral to acquire a loan from a broker. Margin is mainly the difference between an investor’s account value and the loan they request from the broker to execute a trade.
The main goal of margin trading is to gain more returns, but drawbacks exist.
Pros of Margin Trading
- Increases buying power.
- Has a more significant return potential.
- Has the ability to diversify into other assets.
Cons of Margin Trading
- One must meet and maintain margin requirements.
- Has a higher risk than trading a cash account.
- One is required to pay interest on borrowed funds.
The collateral one provides is known as the margin. The trader then selects the leverage they wish to trade at.
For instance, if the leverage ratio is 10:1, a trader can open a margin position for $10,000, meaning they only need to invest $1,000 as collateral.
Additionally, margin trading allows a trader to trade in perpetuity. This means a margin position can remain open as long as a trader wishes, provided they have enough funds to keep their positions afloat.
When a margin trade goes against their favor, traders must answer a ‘Margin Call.’ The call requires them to invest margin or collateral into the position further to avoid liquidation. The margin call keeps a trader from taking any more risk, as their account may be at risk of stop-out.
Margin is used to hedge against price and portfolio capitulations.
One uses margins to trade leverage. Leverage in crypto results from borrowing money to trade securities using an account’s margin feature. Leverage has the potential to work to the benefit or detriment of an investor, depending on the movements of an account’s holdings.
In forex trading, most companies use leverage to amplify returns on their investment projects. The same logic applies to trading equities. One may see substantial upside returns or even see their account value drop instantly if the market moves against them. Thus, trading with leverage becomes riskier than using one’s cash.
Opting for leverage trading without complete knowledge may result in heavy losses.
Leverage works as a loan, and exchange may loan one extra position size against the collateral one provides. It can allow you to invest $1,000 in a certain asset, even if you possess $100 only. The $100 acts as collateral, and the collateral is known as a margin. Leverage is always multiple of the margin funds. It can be either 2X, 5X, 10X, and so on.
Pros of Leverage Trading
- Has the potential for enhanced returns with a minimal deposit.
- Gives a trader access to high-priced coins.
- Also gives traders access to many markets with limited capital.
Cons of Leverage Trading
- There is the likelihood of losses happening fast, leading to margin calls.
- Borrowing fees and margin interest can be costly.
- Managing multiple leveraged positions can be cumbersome to a trader.
Leverage is the percentage of the total order value one puts on a margin trade. More openly, leverage gives one increased buying power by allowing one to open larger positions than they would ordinarily be able to if they could only use the money in their account.
Leverage is mostly described as a ration. Such as 1:10, 1:20 or 1:30.
If one’s stocks go up, the profit margin is the same, and the reverse is also true.
How to Manage Risk when Leverage and Margin Trading.
Margin trading amplifies gains but can also amplify losses. Here are some tips on how to manage the risk.
- Stop Loss- The tool is designed to close a trade at a specific amount in an instance that the market moves in a direction one does not want it to go.
- Not to risk more than one can close- margin trading can go against an individual extremely quickly. As such, one must always invest what one can afford to lose.
- Take Profit- Operates as an opposite of a Stop Loss, where one can take a Take Profit to close one’s position when the profits hit a certain position.
- Negative balance protection- If market conditions cause one’s equity to go negative for some unusual reason, some exchanges will absorb the loss and reset equity to zero.
One can also increase their trade size as a strategy, starting with small positions as one increases their leverage. One can also set clearly defined goals, minimizing risk and dividing their positions. Lastly, one can limit the period between their trades, which limits the risk of unforeseen price drops.
Margin and leverage trading can be daunting at first for a trader. Once they learn a bit more about it and have the will to take a hands-on approach to trade, it can be profitable.
However, one should not be carried away but should risk what they can afford to lose. Set up a Stop Loss and invest in smaller amounts of real leverage, reducing the chances of risk.
Vincent Munene is a freelance writer and a great blockchain enthusiast. Blockchain has changed his life in terms of financial freedom and in return, he likes to educate people and keep them up to date on everything blockchain. He is a Biochemist by profession and also loves to play the piano.