What Is Margin Trading?

If you have been immersed in the world of trading for a while, you most likely have heard of the term “margin trading.” Such a tool has been of immense importance to traders from many different financial markets, but mostly in stocks and crypto trading.

Invented around the 1920s in the United States, margin trading lost its popularity almost entirely after the 1929 crash - regaining momentum in the 1980s and established as an official trading measure after the Chicago Mercantile Exchange created the Standard Portfolio Analysis of Risk (SPAN).

But what is margin trading? In this article, we explain what margin trading is along with different leverage levels according to their risk, the types of operations available and the pros and cons of margin trading.

What Is Margin Trading?

Margin trading is a trading method that allows traders to use funds provided by a third party to fund their operations - usually their chosen trading exchange platform. The objective is to create leverage by operating with a larger position than what you would be able to if using only your own assets.

Therefore, margin trading allows traders to raise greater sums of capital, and take better advantage of positions. However, the same logic works the other way around; while executing larger operations, the risks are also greatly amplified.

Margin trading tools have become extremely relevant in traditional financial markets and crypto, especially over the past couple of years as leverage has become an essential metric of crypto trading flows.

How Does Margin Trading Work?

Let’s say you have $1,000 dollars to invest in a crypto that is worth exactly one dollar as of now. You are extremely positive about that asset, and are absolutely certain that it will go up in value over the next week. Therefore, to enhance your position, you take leverage that allows you to trade $10,000 dollars. Meaning, the exchange platform loaned you $9,000 in what is called a 10x (ten times) leverage.

Let’s look into the best-case scenario: your predictions were correct and, over the course of a week, the crypto went from $1 to $1.50 - a whopping 50% gain. If you decide to cash out, your profits will be calculated based on the 10x leverage you took. For that reason, your profit won’t be $500, but $5,000 instead!

Now, let’s look into the other end of the spectrum; the asset depreciated by merely 10%. While trading with your own money would cause your position to be worth $900 at a $100 loss, with leverage things are different. Basically, since your actual money is only $1,000 on a $10,000 margin trade, a mere 10% loss means -$1,000 or all of your real funds. You then have two options: increase your funds to keep the position, also known as a “margin call,” or take your losses and close the trade - what is popularly known in crypto markets as “getting liquidated.”

Keep in mind that the above example is a general example of how margin trading usually works. Each platform, brokerage firm and exchange has its own approach to the matter, but it generally works as described. As a rule of thumb for investors - the more capital you have, the better credit to conduct such operations. A high net-worth investor with over $10 million dollars in liquid funds, for instance, has a much larger chance of negotiating credit lines for margin operations than someone trading just a few bucks. Not only does this imbalance result in large accumulations of wealth, but it’s also the main reason for the largest stock market crashes in history.

Pros and Cons of Margin Trading

Among the pros of margin trading we can highlight:

• Earn higher profits than you would be capable of using only your personal funds.
• It is an excellent tool for portfolio diversification, where a trader can create multiple positions with little leverage and therefore increase their chances of success if at least one of such positions makes a large profit - thus mitigating risk.
• It is an excellent tool for experienced traders, who can use leverage to really impose certainty on research outcomes for particular market scenarios.

On the other hand, there are also some important disadvantages to consider:

• It may be devastating to newcomers, who do not factor in the risks of liquidation. It is also the main driver of market crashes worldwide.
• It can obviously lead to great losses in capital, so an investor partaking in margin trading must be absolutely certain of the move they are seeking to make - while diversifying leverages for risk mitigation.
• It is not friendly to beginners in the trading practice, potentially leading to bad surprises when positions don’t work out as the investor intended.

Conclusion

Margin trading is a powerful tool to amplify your positions while seeking to reach greater profits in volatile trading markets. While the practice has been used for over a century, and more popularized with the advance of crypto trading, leverage must be taken with extreme caution and most importantly research to back one’s goals and investment proposal. If you are looking to margin trade, make sure you understand the principles of this method, the thesis behind your strategy and also fully read the platform’s margin disclaimers to avoid surprises.