DeFi 101: Margin, Leverage and Liquidations in Derivatives Trading Part 1

Crypto derivatives (CDs) trading remains one of the most powerful and flexible earning strategies for traders. CDs trading has continued to grow immensely with mainstream institutions like Goldman Sachs as it expands the horizen for hedging risk and devising new ways to generate returns in a volatile crypto market.

One of the reasons traders opt for CDs is the protection they offer against losses as a result of crypto price volatility. CDs help to hedge against the risks associated with price fluctuations. They also provide traders the opportunity to make more profits by taking advantage of future price movements of crypto assets. Actions you normally cannot do in the spot markets.

Catch up on details about CDs here

However you gotta stay updated with the many terms and procedures involved for CDs. For this post, we’ll be discussing margins, leverage trading and liquidation.

What is margin and leverage trading?

Pretty sure you’ve heard of margin trading at some point. However, not many have a good idea of what it actually means. Margin trading allows you to borrow funds to enter and hold a CDs position. Picture this, you plan to trade at $10,000 but you only have $1,000. With margin trading, funds are available to you from third parties like other traders from which you can borrow from to increase your leveraged position.

To do this, you’ll need an initial deposit amount (which would be your $1,000) and open a position for the margin trading (i.e. long or short position) while ensuring you have the specified collateral in your account to maintain that position.

In crypto margin trading, you can either open a long position or short position. For a long position, you’re betting that the crypto price will increase at a future time. For a short position, you’re betting that the price will fall at a future time.

This is where leveraged trading comes in. Leverage gives you an opportunity to open larger positions than you would have with the amount you have in your account or your initial deposit. In other words, leverage increases your buying power. Depending on the CD trading platform that offers margin trading, the leverage ratio could be 10x, 20x (i.e. 1:10, 1:20) or more. The higher the leverage, the more risk so think twice.

This way, with your initial $1,000 you can trade with funds up to $10,000 using a leverage ratio of 1:10. Without leverage trading, you would actually need the exact $10,000 to trade. This gives you an opportunity to make a greater amount of profits than you would have. However, on the flip side, you stand a chance of losing as much too! This could lead to liquidation if you’re not careful…

What then is liquidation?

Now this is an important term to be acquainted with. Seriously, wrap your head around it. If after opening a position, say a long position, the price of the underlying asset of the CD begins to fall i.e. going against your initial position and the loss goes beyond your margin or initial capital, you’ll be forced to close your position. This is when liquidation occurs. You lose all of the collateral in your account and your open position is now closed.

A number of factors determine the liquidation price — the leverage ratio, the position you open, and the funds in your account to maintain your position. In the next series, we’ll explain more on these!