Margin trading is a higher-risk trading strategy that professional traders sometimes use. At it’s simplicity, it is borrowing money from the broker (or An exchange is a platform that enables you to exchange one currency for another currency. It is a place where people can... Click for full definition) in order to buy an asset (like crypto).
By using borrowed funds, this allows them to buy more crypto than they would otherwise do using just their own funds. When you buy crypto on margin, that crypto itself is used as collateral for the loan.
As an example, let’s say a trader is buying $10,000 in Bitcoin. He pays $5,000 out of his own funds and borrows the other $5,000 on margin. The entire $10K in Bitcoin is the collateral for the loan. If the loan is not paid back per the terms, the entire $10K in Bitcoin just became property of the broker or exchange. However, that’s not how this usually happens…
The whole point of a trader using margin trading is to increase position and hopefully increase return on investment as the market price of the asset increases. So, in our original example, we begin with $10K in Bitcoin. Let’s say that the value of that investment goes up to $12K. That’s a 20% increase of $2,000 in market value. Thing is… the original cash outlay was only $5K originally. Your gain of $2,000 on the trade is actually delivering a full 40% return on investment (you made $2,000 on a $5,000 investment). You “pay back” the margin call and keep the profits.
Of course, that’s a rather simplified example, but it illustrates why a trader would might consider using margin trading.
It is a riskier strategy, however, since it can magnify losses, too. In the above example, let’s say the investment fell by $2,000 rather than increased. As the math goes, you just lost 40% on your investment rather than made a profit.
One must also keep in mind that, like any loan, there are extra fees associated with margin trading. They don’t hand out loans for free. 🙂 So, you’re paying interest on that loan until you pay it back to the exchange. The shorter time period you hold the margin call open, the less interest you will pay. If you hold it longer term before it is paid back, you pay more interest and must consider this on how it will impact your returns.
Margin trading is a double-edged sword. With greater power comes greater responsibility. Misuse margin trading, and you can lose a lot of money. On the flip side, though, it also allows you to generate nice returns on an increasing market without much in the way of starting capital.
This is a strategy best used by professional traders. For most people reading this definition, I don’t recommend that you use margin trading.