Cryptocurrency margin trading: how it works
What is margin trading?
Nowadays, more and more leading cryptocurrency exchanges enable the users to experience margin trading, seducing them with a possibility of the high future profits without any other personal investments to the trading process. It’s quite perspective to use margin loan, but it has some important subtleties. So, it would be reasonable to know the main principles of this financial instrument.
What is the nature of margin trading? In fact, it is a kind of funds trading. A trader borrows these funds at a particular exchange, and exploits its deposit as a guarantee (the term “margin” is a synonym to the term “guarantee”). The exchange also benefits from granting the credit to a trader. The specific commission that you have to pay to use credit funds is meant (for example, daily, 0.1% from the trader’s total sum; it’s quite bearable, and as we’ll see later - there are even more significant “reefs” in the margin trading).
Margin trading has several important features:
1. Credit funds are provided to buy the assets, such as bitcoins, and are fundamental to “trade with the leverage”. In this case, you can get not only a number of assets which you are able to buy on your own but also some extra assets that you would be able to buy on the money lent to you by the exchange. In other words, the leverage is a loan for a purpose, temporarily increasing your deposit to a certain amount (under the index of leverage).
For you to understand better the leverage trading mechanism, we’ll illustrate it with the particular examples in the next section of the article.
2. Reflecting on the above, in margin trading your own deposit is a kind of a guarantee. Furthermore, the exchange is seeking to minimize the risks and protect itself. If the price goes down, the exchange won’t bother your trading practices for a long time; however, the exchange will definitely shut down your activity if the price decreases dramatically(double decrease with the leverage 1:2, for instance), and if there is a risk for you to lose your own, and borrowed funds. At the same time, the loss resulted from the price break of the borrowed asset would be covered by your deposit. Such operation is known as “margin call”. Later, we’ll determine the size of the drawdowns threatening of “margin call” and how to minimize the risk of its occurrence using some additional exchange instruments.
3. Summarizing the previous statement - if you buy cryptocurrency for borrowed funds, you can’t withdraw it from the exchange on the same conditions applied to your own currency. 4. The procedure itself is not complex, and if you want to get a loan there is no need to contract with the exchange. Make it sure to verify your account on the exchange platform to find out whether you have funds to be used as a margin.
How to profit from the margin trading?
Let’s look at the particular case describing how leverage is functioning in margin trading. We’ll first start describing margin trading with “long” position due to its simplicity. In this case, you buy cryptocurrency, wait for its price increase, and sell it pricier than you’ve bought.
Growing market margin loan
Let’s imagine that your deposit values $300 at the margin lending exchange, a single ETH also values $300, and you are certain about the mentioned cryptocurrency’s value going up. Then, you select the leverage of 1:5 as the most appropriate in this particular context. Let’s say that the fee you have to pay for the borrowed funds is 0.1% per day (0.1% is equal to 0.001off the credit amount).
You get 1 ETH for a price of your own funds and another 4 - using the borrowed ones. After this, ETH price can change in various ways - increase, decrease, and flat (when the price neither rising nor declining). So, let’s have a closer look at them.
1. If ETH rate rises up to 360 USD during two days and you trade ETH at the peak of the price, your net profit will be 297.6 USD (1800 minus the deposit of 300 USD, credit of 1200 USD and percentage of 2.4 USD):
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Please note, that if you operate in the same trade context, excluding the leverage, your profit would make 360-300=60 USD. In other words, in the leveraged trading, the primary profit multiples first by the leverage index, and then, decreases by the percentage of the commission taken for the use of credit funds.
2. If the ETH price goes down and reaches turning point, you may lose the total amount of your deposit due to the “margin call”. In our case this turning point would be slightly above 240 USD for 1 ETH. It will happen so because any price below this mark is too small, and even if you sell all your ETH (for 235 USD e.g.) you won’t be able to repay the loan, which is unacceptable in the exchange context. In this case, the margin call price is not equal 240 USD because the sum you have to return also includes the credit interest. Consequently, the longer your credit use term is, the more money you need to repay the commission fee.
Generally speaking, you can calculate the price preceding the “margin call” by multiplying the current asset price (CP) to the exchange share (ES) in assets that you have bought plus credit interest (CI) and the current credit term (CCT) which is 0.1% off the credit interest per day in this case . The exchange share under the leverage of 1:5 will make (5-1)/5=0.8=80%, under the leverage - 1:10 (10-1)/10=0.9=90%, and so on.
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So, whenever you buy 3 bitcoins for 4 000 USD under the leverage of 1:10, the credit funds will cover 9/10 (90%) of assets’ purchase expenses. Thus, in 2 days,the turning point for margin call will be up by 0.2 % - 4000*0.9=3600 USD. That means it would be equal to 3600*1.002=3607.2 USD for one bitcoin.
3. Finally, if you are bargaining for dramatic price growth, a so called “flat” may happen in some cases - the absence of essential assets price movement. Such a price “calm” can last for several days, or even weeks, which is more seldom and depends on a generic asset volatility. However, even if you don’t sell the leverage bought asset during long period of time, the credit interest won’t be too high. Let’s use the aforementioned case with ETH to calculate the sum of credit interest for different payment terms (in this case, the percentage used for margin loan is supposed to be simple, not complex one). The credit amount could be estimated as 1200 USD, the credit interest would be:
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1200*0.1%*30=36 USD ( in 30 days after establishment of the credit) 1200*0.1%*120=144 USD ( in 120 days after establishment of the credit) 1200*0.1%*249=298.8 USD ( in 249 days after establishment of the credit) 1200*0.1%*250=300 USD (in 250 days after establishment of the credit)
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In the last case, if the price is not changeable, the total interest would be equal to the amount of guarantee funds, while the margin loan would be paid by these funds ( even if a day before this you could have had the total control over the assets). In practice, during the stated period of time,a “margin call” is more likely to happen, or dramatic price increase.
In addition to the accumulation of total interest, described in the examples 1) and 2), there are some other consequences: your net income is going down, while “margin call” price and general loss are increasing. All these negative consequences become significant only if the long term payment delays for example if you don’t pay the loan back during several months. It is also highly recommended not to forget about your margin loans and put trading aside before closing the positions, which were opened for assets loan.
Whenever the price goes down you can either hope for better times and wait for its increase, or decide on selling the asset before you lose the whole deposit. Additionally, if you are certain about future price trends and think the drawdowns to be temporarily - you can credit your exchange account to postpone a“margin call” actuation point.
In the second case, your loss (analogy can be made with the profit discussed in the case above) would be equal to the change in price multiplied by leverage index, and adjusted to the credit interest.Let’s return to our example with ETH bought for 300 USD. You can earn 1400 USD if you sell them in two days for 280 USD, but after paying back the margin loan and its credit interest you will have only 1400-1200-2.4 = 197.6 USD, which will be your net deposit.
Some traders use a special kind of order at the exchange known as “stop loss” to protect themselves from the ‘margin call’. a trader creates his order and sets the price-sensitive trigger to sell automatically the asset (to avoid bigger loss in the context of any further price decline) to be activated whenever the price goes below particular mark.
E-mail notifications (so called “alerts”) are available at some exchanges. They inform users about “margin call” danger and remind that they may close the position, or credit their exchange accounts with extra funds.
Falling market margin loan
You can also use margin lending to get profit if the price of some assets drops gradually (even if the price break is not yet evident, but you are expecting for it). The principle of margin loan slightly differs in this case from the one that was described above.
You should open a so called “short” trading position to get a profit. It means that you should borrow some amount of asset before its presupposed price decline and sell it; the amount of asset you can borrow depends on the guarantee you can provide.
After this, you should wait until the price goes down, and then, buy the same assets paying with money you’ve got while selling them. Since the bid price is lower than the primary selling price, you will be able to purchase the same amount of asset, which you have borrowed from the exchange while opening the position. After the repayment of margin loan and its credit interest, all extra funds will make your net income.
If the ETH price is equal to 350 USD and you have the guarantee of 1050 USD, you can borrow 3 ETH without using the leverage; after getting your borrowed coins, you can sell them for 350*3=1050 USD. Supposing your predictions are true and the ETH price drops, for example, to 280 USD - you will be able to recover the amount of 3 ETH for 840 USD, return them to the exchange, and get 210 USD of profit (actually, you will earn a bit less due to the credit interest). If ETH price reaches the turning point, in the described case, that would be a little bit lower than 700 USD - the “margin call” will occur. It is crucial to consider that whenever the price exceeds the stated level it is impossible to buy, and return ETH borrowed from the exchange in full, and pay the credit interest.
While opening short positions to increase your income you can also use the leverage, according to the scheme, similar to the one described in the previous chapter. Of course, if you use the leverage, there always will be some risk of “margin call”, if the price starts growing instead of supposed negative trend. You can further minimize the risks of “margin call” using “stop loss” and alerts.
To sum up, if a trader is able to successfully determine the price trends on the cryptocurrency market, he/she will find the margin trading as a useful instrument, allowing to multiply the profit with no need to invest his own funds in circulating capital. On the other hand, at the beginner’s disposal this instrument may become very insidious, just like at a trader’s one, especially if he/she is operating regardless the risks. It is also important to consider high price volatility (the last one is more typical to altcoin trading, bitcoins are more stable). That’s why you should be very careful while using margin lending. Thoughtful usage of “stop loss” and alerts will prevent you from losing your assets - thus making your margin trading more successful.
