The Ins-and-Outs of Trading on Margin

What Is Trading on Margin?

Trading on margin is similar to the phrase “buying on credit.” Using margin for a trade is also known as leveraging, because it involves borrowing money to lever, or boost, the value of a trade.

Margin money is a loan with an interest rate and collateral attached — both of which are set by the broker. The margin interest rate depends on how much you borrow and your relationship with the broker. Cash and stock are popular forms of collateral typically used by margin traders and are based on the account’s size and type of security being traded. Traders must also maintain a margin balance, known as the maintenance margin, in their accounts to cover losses.

Why Trade on Margin?

• Short sales: Margin is commonly used in short selling. When you short sell a security, you are betting that the price of a security will decline at some point in the future, a process often known simply as “shorting.” Trading on margin amplifies the size of a short and, therefore, its profits. But the opposite is also possible: the potential for losses can be severe if the trade goes awry.

• Managing risk: Traders also use margin as a risk-management tool to minimize, or hedge, their losses. For example, you can hedge a long bet on an asset’s price trajectory by shorting the same asset with an equal or lesser amount. Suppose you have $10,000 in your trading account and your broker allows you to borrow up to 50%, or $5,000, as margin. Your trading balance then becomes $15,000. If your purchased shares rise by 10%, you could gain $150. But if they decline by 10%, then you stand to lose $150, or $50 more than if you hadn’t borrowed anything at all.

Margin Calls Are Important

A margin call is a way to ensure that you have enough funds to cover any shortfall in your account, including interest, should your trade result in a loss. Loans made to traders by brokers are considered “mark-to-market,” meaning that a loan’s value changes along with the price of a security as it trades. If a security’s price declines, your account balance can fall below the maintenance margin amount. If the price falls to a point where equity (cash plus stock) is less than the maintenance margin requirement delineated by Regulation T, then the broker can issue a margin call. If you get a margin call, you must deposit assets that bring the account back up to the minimum requirement, and if you fail to do so, the broker can liquidate all or some of your assets without notice.

You can find out more about the requirements for trading on margin from the Financial Industry Regulatory Authority (FINRA).

Trading on Margin With Cryptocurrencies

Most traditional brokerages do not list cryptocurrency trading, much less margin trading, among their service offerings. The volatility associated with cryptocurrencies has mostly dissuaded individual traders from placing large bets using margin trading capital. According to reports, 70% of all current cryptocurrency trades are conducted through API calls by institutional investors. In lieu of brokerages, cryptocurrency exchanges have emerged as popular venues for trading on margin, but not all exchanges offer the service.

Of the exchanges that do offer trading on margin, the leverage amounts and interest rates for margin trades differ based on customer demand and regulatory differences across distinct geographical locations. Some European-based exchanges offer leverage up to 125 times for certain futures contracts. The interest rates on margin loans at various exchanges also differ. Some charge an annualized interest rate for a loan while others calculate the loan rate on an hourly basis.

A common misconception about trading on margin with cryptocurrencies is that individual traders can execute arbitrage strategies between different geographical locations. But this is not entirely true: Some regulated cryptocurrency exchanges restrict trading to citizens or expatriates living in that country. Exchanges help implement all-important regulatory and compliance guidelines by following strict Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements that require proof of identification of each user that makes use of the exchange platform in that country.

Three Key Factors to Remember About Trading Cryptocurrency on Margin 

• First, the cryptocurrency asset class is not regulated uniformly across the globe, which can be detrimental to your trades. For example, a ban on cryptocurrency exchanges like the one imposed by China in 2017 could potentially wreck havoc on the value of your portfolio.

• Second, cryptocurrency and crypto tokens are a relatively new asset class with price fluctuations that have heretofore followed unpredictable patterns with little to no correlation to technical or fundamental analytic principles in mainstream markets. As such, cryptocurrency trades made on margin could result in magnified gains and losses. Again, because of this fact, it is critical that only experienced traders that understand risk management practice margin trading.

• Finally, margin trading requires a strong understanding of the global cryptocurrency marketplace. There are, quite literally, hundreds of cryptocurrency exchanges throughout the world. For every well-known legitimate exchange, there are numerous questionable operations that are not trustworthy and their use can result in the loss of user funds. Therefore, before you consider trading on margin at all, especially bitcoin margin trading on a crypto exchange, it’s critical to thoroughly research the platform you choose to use.