Margin trading in crypto offers users one of the easiest ways of investing for higher returns, although with higher risks too. Essentially, in margin trading, the trader borrows funds from the cryptocurrency exchange to carry out a trade they cannot afford, that is, the trader has higher buying power and can open larger positions to earn more. Let’s explore a few terms that are commonly used in margin trading for easier comprehension:

Leverage

Leverage simply refers to the use of borrowed funds to trade. The crypto exchange or broker borrows traders extra funds so they can make transactions higher than what they can afford. This enables them to make larger bets in hopes of earning bigger profits.

For instance, a trader has $2,000 and thinks the price of Cardano (ADA) will increase. They can either buy ADA directly with the $2,000 or leverage a position to trade on borrowed funds. If the trader buys $2,000 worth of ADA and the price increases by 20%, the investment will be worth $2,400 (the $2,000 capital and $400 profit).

The trader may harness leveraging to further improve their stake. Using 5x leverage, for example, the trader will borrow four times their initial capital and boast of higher funds to invest with. In our example, the trader will borrow $8,000 from the exchange, making a total of $10,000 in investment funds. With a 20% increase in ADA price, the $10,000 investment will be worth $12,000. The trader pays back the borrowed $8,000 and is left with $4000. That is a 100% return on their initial investment.

However, crypto trading is not always as beneficial as earlier outlined. Imagine an opposite scenario where the price of ADA dropped by 20%. The investment without leverage will suffer a 20% loss, leaving the trader with $1,600. But with the 5x leveraged position, the trader suffers a 20% loss on the $10,000, leaving them with $8,000. The exchange platform takes the borrowed $8,000 leaving the trader with nothing (100% loss). Note that the examples presented throughout this article show a simplified scenario and don’t take trading fees, loaning interests, and other factors into consideration.

Margin

Another term to explore is margin. Initial and maintenance margins are two margin requirements in margin trading. Initial margin refers to the amount of collateral the trader must commit to open trade while maintenance margin is the minimum amount needed to keep that position from getting liquidated. If the asset fluctuates and goes below the maintenance margin, the trader gets a margin call which signifies that they will lose the position and they need to put more funds into the account to keep the position open.

Liquidation

If the trader fails to meet the margin call, the crypto exchange may be forced to sell the asset in the account to offset the borrowed funds the trader used to leverage. This act of losing all the initial margin is called liquidation.

Cover image source: Coinbase