Cryptocurrency margin trading is very popular among traders as it multiplies earnings without increase of investments. Sadly, like any other earnings with potentialy large profit, it's rather risky But if you understand its aspects well, you can minimize the risks. In this article, we speak about them!
What Is Margin Trading In Cryptocurrency Exchange?
Cryptocurrency margin trading is a kind of speculative operations with cryptocurrency in cryptocurrency exchange.
It differs from other traders' games in that the player speculates not only with own assets but also with loan assets which he takes on credit from the exchange charged upon own assets.
Using loan assets, the trader can buy and sell several-fold larger amount of cryptocurrency than he would be able to do it if he used only his own capital, hence, the profit of successful operations increases proportionally — in several folds.
The name "margin trading" itself derived from the word "margin" which in this case roughly stands for charge. The player's own assets which he provided as a charge taking the credit are the margin.
The margin trading works in accordance with the following principle.
Let's presume that an investor has 100$ and is sure that some cryptocurrency, for example, Litecoin, will grow. He wants to buy it now and to sell it later making profit out of difference between prices. But he can buy only 1 litecoin for 100$ (actually, even less but let's presume it for illustrative purposes). It's too little.
Then he goes to cryptocurrency exchange allowing margin trading and takes money on a loan there. In fact, he borrows not from the exchange itself but from another cryptocurrency investor who grants credits to everyone interested at specific interest.
Generally, the creditor sets the interest rate by himself when he decides for which sum he's ready to let another person use his assets. Due to this fact, the interest rates are different in various exchanges and for various cryptocurrencies.
The exchange specifies maximum sum which the player who needs money can take on a loan from a creditor. This sum is referred to with the term "credit leverage" and specified as a ratio.
For instance, 1:1 credit leverage means that the player may take on a loan the same amount as he has on own account. In our example, it's 100$. 1:2 credit leverage allows him to borrow two times larger amount than he has on the account — its 200$ in our example. 1:3 credit leverage allows the player having 100$ to borrow 300$ and so on.
For the whole loan amount plus his own assets, the player can buy the abovementioned litecoins. So, while he could buy 1 litecoin for 100$, he can buy 4 litecoins for his 100$ plus borrowed 300$ (if the credit leverage is 1:3).
If the price of Litecoin increases by, for example, 20% and will is equal to 120$, the player will sell his 4 coins for 480$ and will get profit equal to 20$×4=80$. These 80$ minus transaction fee for the exchange (0.1-0.2%), credit fee (about 0.2% too) and credit interests will stay on his account.
100$, his intial assets, stay on his account too, and 300$ are transferred back to the creditor. So, net profit will be equal to 80$ minus interests and fees, apparantly, about 75$.
If the player hadn't used loan assets and had traded only with his own 100$, he would've gained profit equal to 20$ minus exchange fees.
Cryptocurency Margin Trading: Aspects
When the player's expectations are satisfied, the situation is profitable for everyone: after the transaction is successfully completed, the player returns assets and interests to the creditor and has his own profit. But the player's expectations may remain unsatisfied.
For example, price of Litecoin from abovementioned example may not increase by 20% but decrease by 20%. In this case, the player who've bought 4 litecoins for 400$ can sell them only for 320$, with loss of 80$.
Of course, the creditor can't suffer due to the player's dampened forecast. That's why, when price of the player's assets (both own and borrowed) reaches amount of the credit with interests, the sum the player must return to the creditor, the exchange automatically closes all the player's positions and returns the creditor his assets.
Herewith, the sum returned to the creditor includes the full margin, which is the player's initial assets provided as a charge. In this case, he loses not only borrowed assets but his own ones too.
This situation is called the "margin call". That's the name of the call the broker gave to the client in those times when interaction between the participants of the exchange was performed by means of telephone.
Margin call warns the player that the limit after which his assets will be written off of his account and transferred to the creditor is near.
To prevent it, the player may refill his account telling the exchange that he's ready for further decrease of the price (and expects it's further increase). Or he can do nothing and wait for automatic closure of the position.
Another distinction between margin trading and ordinary trading is that, when buying cryptocurrency without credit leverage, the trader starts owning it, so he's able to pay it out, spend and so on. When buying it with credit leverage, he can't pay off neither it nor the margin as the exchange doesn't allow him to do it.
Cryptocurency Margin Trading: Secrets of Success
Success of margin trading mostly depends on the trader's skill.
Speculation strategies of margin trading doesn't differ from ordinary trading. The Trader may either open a short-term or a long-term position if he expects that the cryptocurrency will either increase or decrease, or to start doing pumping and dumping for loan money if he's sure enough.
In this case, the risk is larger because in case of failure, he loses x of own assets when buying without credit, and 2x, 3x, or more, depending on credit leverage ratio, when buying with credit.
But, in order to make maximum profit during margin trading, it's worth considering a number of nuances and traps and pitfalls:
- First rule of successful margin trading is never bring the situation to margin call.
It means that when the price begins changing adversely and his losses inclusive of the credit and the interests reach 20-30%, all assets purchased for credit money will be automatically put up for sale at market price and the credit and the interests will be returned to the creditor.
So, the trader's losses will be equal to 20-30% rather than 100% which would've occurred in case of margin call. Such automatic sale (or purchase) order of asset at a limit price is called "stop-loss".
Sometimes the trader may be sure that the price of assets purchased for credit money will increase again after its decrease. In this case, he timely refills his account with the sum allowing not to reach margin call, for example, the whole sum of the loan or 50-70% of it.
In this manner, he excepts the risk of automatic loss of assets during margin call and calmly waits for growth of the cryptocurrency. But it's worth noting that it's a risky strategy which requires assurance that the price will increase, which usually arises out of mathematic analysis of the market and is rarely based on intuition only.
- Second rule: before taking on a loan, it's necessary to calculate potential value of accued interests of the creditor.
If the interest rate is high (for example, the creditor grants credit for rare cryptocurrencies) and the player uses the credit for a very long time, the final payments to creditor may reach sufficient values.
- The third rule is to choose cryptocurrency for speculation with attention.
Plus, the larger the credit leverage is, the larger is the risk. And it doesn't matter if the currency grows after slump: if the margin call happens, the player loses money automatically.
But the currencies which almost don't fluctuate are not good for margin trading either. If the currency stands still, the investor who've bought it without credit leverage won't lose anything. But the speculant who've bought it for borrowed money will have to may accrued interests to the creditor.
If growth of the currency is low, almost all the profit may be spent for interests and sometimes the player has to spend his own assets to pay the debt.
- The fourth rule: it can't be forgotten that, independently of what was the credit currency, the charge contains assets on the trader's account.
As a result, value of margin automatically decreases and margin call becomes closer although the trader may have no losses resulting from unsuccessful trading. That's why it's important to pay attention for relevance of price of the charged assets to their price at the moment of the loan.
Cryptocurency Margin Trading: Recommendations for Novice Traders
There are some universal recommendations for the players who've decided to try their hands at margin trading:
- Start with low loans. It means, to take the credit not at leverage of 1:10 multiplying the risks by 10 at ones, but at leverage of 1:2 doubling the risks.
- To determine the sum which can be lost without damage to own financial situation and to take credits equal to not more than 10-30% of this sum. It means that if the investor can afford himself to lose 1000$ at exchange, he has to refill the account with 1000$ and take credits for 100-300$.
- Define limit orders (stop-losses) at 20-30%. In case of following the previous recommendation, losses will be equal to 20-90$ which, although it's undesirable, is appropriate when initial capital is 1000$.
- Choose familiar cryptocurrencies. It's not worth starting with cryptocurrency if the trader sees its swing chart for the first time. It's worth trading it without credit leverage and understanding how it behaves itself on the market, what ensures its value and what factors its price depends on. When trends are defined, then is' worth takin on a loan.
- Take the credit in an intelligent way. It makes sence when margin trading is much more reasonable than ordinary trading. For example, if the price of the currency is jumping or if there are good reasons for it (good news, issue of prospective fork and so on).
From the other hand, the larger the credit amounts are, the larger the risks are, and it's a common rule. That's why novice player should be careful, not let his emotions run away with him, and remember that in trading games, greediness is not the best policy.