What Does Margin Trading Mean in Terms of Cryptocurrency?
Margin trading with cryptocurrency allows users to borrow money against their current funds to trade cryptocurrency “on margin” on an exchange. In other words, users can leverage their existing cryptocurrency or dollars by borrowing funds to increase their buying power (generally paying interest on the amount borrowed, but not always).
For example, you put down $25 and leverage 4:1 to borrow $75 to buy $100 worth of Bitcoin. The only stipulation is that no matter what happens, you’ll have to pay back to $75 plus fees. In order to ensure they get the loaned amount back, an exchange will generally “call in” your margin trade once you hit a price where you would start losing the borrowed money (as they will let you borrow money to trade, but they don’t want you losing that money). A margin call can be avoided by putting more money into the position.
A given exchange will have a range of different leveraging options (2:1, 3.33:1, 4:1, 1000:1, etc.). Margin trading can be done short (where you bet on the price going down) or long (where you bet on the price going up). Further, it can be used to speculate, to hedge, or to avoid having to keep your full balance on an exchange.
Below we explain the basics of margin trading and warn of some of the risks.
TIP: Some exchanges will only offer margin trading to investors who meet certain stringent criteria, others are more flexible and will let you trade on margin if you have enough funds to cover the trade. For an example of an exchange that requires meeting criteria, with GDAX you must be an Eligible Contract Participant (“ECP,” as defined in Section 1a(18) of the Commodity Exchange Act and applicable regulations thereunder). That means if you aren’t an accredited investor or don’t to have access to a good bit of capital individually or through a partnership, then you cannot do margin trading on GDAX. Meanwhile, Kraken allows margin trading for all of their Tier 1 – 4 clients.
TIP: You’ll most likely want to “turn margin trading off” if “margin trading is on” when you first join a cryptocurrency exchange (as many exchanges allow margin trading). This will help prevent you from “making a leveraged buy on margin” while getting the hang of cryptocurrency trading.
“Imagine this: you’re sitting at the blackjack table and the dealer throws you an ace. You’d love to increase your bet, but you’re a little short on cash. Luckily, your friend offers to spot you $50 and says you can pay him back later. Tempting, isn’t it? If the cards are dealt right, you can win big and pay your buddy back his $50 with profits to spare. But what if you lose? Not only will you be down your original bet, but you’ll still owe your friend $50. Borrowing money at the casino is like gambling on steroids: the stakes are high and your potential for profit is dramatically increased. Conversely, your risk is also increased.”
– Margin Trading quote from Investopedia which explains how margin trading is like a casino… within a casino… within a casino…
How Margin Trading Cryptocurrency Works – Leveraging
The with introduction covered, let’s cover some of what we touched on above in detail.
Margin trading is in simple terms just borrowing funds to leverage your bet. You take extra risk for the chance of extra reward. Logically, this is something you primarily want to do when you think the odds are in your favor.
With margin trading you can, for a theoretical example, buy $10,000 worth of bitcoin with only $5,000 (borrowing 50% AKA leveraging 2:1 or 2x).
You put down your $5,000, you borrow the other $5,000 from a lender automagically (generally either borrowing from the exchange or other traders), and then when you sell you may-or-may-not pay a fee (that fee being interest on the money borrowed).
With that said, because you are borrowing money, you owe the money back along with any applicable fees, no matter what.
That means if you bet on cryptocurrency going up, and it goes down or stagnates, and you have to sit on your coin, you’ll rack up interest in cases where interest is charged. That also means, if it goes down, you’ll owe what you borrowed plus any fees even though you lost money.
TIP: You can leverage short or long. When you short you bet on the price going down (and if it goes up you lose money on paper). When you go long, you bet on the price going up (and if it goes down you lose money on paper). The amount you lose is based on your total bid size, so make sure to use risk management. The position doesn’t close until you close the position manually or at a set price or the exchange calls your position in because you run out of funds allotted to the position (see next section).
How Margin Trading Cryptocurrency Works – Call Prices and Liquidation
This brings us to the next point. As noted above, you have to have enough funds to cover the bet you are taking. If you don’t have the funds, your position will automatically be closed, “liquidated” or “called in.” As, although the lender will let you use their money for a fee to margin trade, any money lost and any fees paid will come out of your funds. This is like the friend who let you borrow $50 in the Investopedia quote above; the lender is letting you borrow money, not have it to lose.
Specifically, if your balance falls below the “Maintenance Margin Requirement (MMR)” due to the price going the opposite way that you bet on, the exchange will either start liquidating your assets to get its money back or will simply request the funds from you. This is called a “margin call.” TIP: A margin call can be offset by contributing more funds to the order book you have the margin in (ex. BTC/USD). When you deposit more funds, you increase your margin ratio and improve your call price.
In other words, technical jargon aside, the concept here is: margin trading allows you to make bigger bets than you otherwise would at the cost of extra fees and extra risks. When you take a bet, you can use the lender’s money, but if the bet goes the wrong way, the funds come out of your pocket. You take all the risk.
That is the gist of margin trading; with that information, you know just enough to be dangerous.
TIP: Consider setting stops and hedging margin positions with another margin position or with spot buying (actually buying a crypto). The market can be tricky, and margin can be risky, but if you practice proper risk management tactics and learn some TA you’ll go a long way to mitigate potential risks.
TIP: How much you can leverage differs by exchange and product type (for example on an exchange BTC/LTC might be 5x, but BTC/USD 2x). Other specifics will differ by exchange too, so always read the documentation before you initiate margin buying.
Should I Do Margin Trading?
We strongly suggest staying away from margin trading unless you have done research, are experienced, and are margin trading with a very specific purpose such as hedging. Losing money trading cryptocurrency is stressful enough without borrowing funds plus interest to create leveraged positions. That magnifies your stress level.
Of course, if you are less conservative than we are and want to trade on margin anyway, your next step should be reading all the documentation on margin trading for a given exchange before getting started. Understanding how to open and close margin positions, and making sure you understand margin ratios and calls, as well as brushing up on some margin trading strategy, is part of the next step. We’ll assume you are already well versed in technical indicators.
WARNING ON RISKS, RATIOS, AND BET SIZE: Margin trading cryptocurrency is one of the riskiest bets you can take. Cryptocurrency is risky, and margin trading is risky. Put them together on a highly leveraged moonshot, and you could find yourself owing a great deal of money rather quickly (especially with low volume high volatility altcoins). Unlike with regular trading, you can lose your entire initial investment margin trading. Further, the more you leverage, the quicker you can lose it. For example, if you go long on a 4:1 margin and the position goes down about 25% from where you opened the position (or a little less since you’ll likely owe fees), the margin will be called in, and you’ll be left with nothing. Think of it this way; you put down $25, you borrowed $75, and thus with fees you only have a little under $25 to lose of the total $100 you are betting. If it goes up, then you can keep the position open as long as you like (as you aren’t risking the lender’s $75), but if it goes down your position will be liquidated based on the rate at which you are leveraged unless you put more funds in. Do an 8:1 leveraged position and it will be called in twice as fast at around 12.5%, do a 2:1 position and it will be called in at around 50%. Yes, you can always add to your position to prevent it from closing, but this is the exact sort of rabbit hole that loses people money. For an obligatory horror story and fair warning of the perks and perils of margin trading, see the Reddit post “How I Lost Nearly 200 BTC trading this past month.”
TIP: Margin trades have time limits. If you can’t execute your trade-in time, the leveraged portion of your trade may be automatically settled.
TIP: Margin trading essentially works the same way on stocks. In both cases, if the exchange will let you, you can leverage a long or short position. Shorting can be very risky, especially on margin, but it can also act as a hedge. If you buy a lot of BTC at a given price, you might want to take out a small short position as a hedge to protect you in case the price drops. Using margin shorting is a hedge is considerably less risky than using leveraged positions to speculate on the price.
TIP: If you are going to speculate on the price of a coin using margin trading, make sure to do an overview of technical analysis concepts like RSI first. Blindly speculating with leveraged positions is a recipe for disaster, even the pros will caution you against it.
TIP: One benefit of margin trading is that you can use it to keep less cryptocurrency on an exchange at a time. If you have a lot of cryptocurrency and want to protect it, it can make sense to keep the bulk of your funds in “cold storage” (an offline wallet) and to keep only enough on the exchange to trade with using leveraged buys (buying on margin). This tactic is also far less risky than simply speculating with leveraged positions, although it carries the same general risks; you can end up seeing a position liquidated during a downturn. When you buy crypto and hold it, it doesn’t matter how bad it gets as long as it comes back at some point in the future. When you margin trade, short-term price movements can force you to close a position and lose money.
ON MARGIN TRADING AND TAXES: Margin traders are constantly making short-term capital gains and losses, and thus they are subject to the short-term capital gains tax (both its rate and the requirement to report trades and pay quarterlies). Meanwhile, those who simply hold crypto avoid this and, if they hold long enough, can enjoy long-term capital gains rates. There is a lot of pros and cons to consider if you are thinking about margin trading.