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The Risks of Margin Trading

marginfi is a decentralized margin protocol for trading across Solana. The protocol makes it easy for traders to access margin, manage risk, and improve capital efficiency across the entire Solana ecosystem from one unified place.
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This article is a continuation of the marginfi Leverage (learning) series.

Hello Traders! The last few articles have explained the basics of margin and margin trading. While we’ve often alluded to the benefits and potential rewards of using margin, in practice it is very easy to lose money. As such, there’s no better way to conclude our overview on margin than by explaining the risks so you can degen responsibly.

You can find the rest of the articles in this series here.

Risky Business

Margin trading is risky for many reasons. The most glaring is the amplification of returns/losses but many of the risks are due to the way margin accounts are actually structured. Let’s look at the four major risks associated with margin trading, starting with mildly inconvenient ones and working our way up to guh-moment-sell-your-house catastrophes.

The Four Key Risks

Amplified Returns

The most obvious risk trading with margin is the amplification of returns. While using 100x leverage might enable you to make great sums of money with little starting capital, it also makes it very easy to lose money. This is what’s meant by amplifying returns rather than simply increasing them. Margin moves in both directions.

Leverage giveth, leverage taketh

Margin Calls!!

In our last article we talked about how margin requirements are set. One of the early distinctions in that piece was that margin accounts have a notion of both initial and maintenance margin. Maintenance margin is set by the broker to determine how much margin must be in the positions at any given time. This means that even if you have not hit your liquidation threshold, the position may still be at risk.

This risk comes in the form of a margin call. The term is often used in popular culture whether it be the eponymous movie or Wall Street Bets threads but most people have not actually had one or understand what it entails. A margin call was originally an actual phone call from your broker stating you needed to put up more margin. Today it mostly comes in the form of ominous red UX and large letters saying “margin call.” Brokers issue margin calls to warn traders that a position is likely to be liquidated and give them a sort of grace period to re-up and keep the position live.

If the maintenance margin is not met after a margin call, it will likely result in the broker forcibly selling the assets. In DeFi, there is no warning system like this. The position is sent straight to liquidation.

Force Sale of Securities

Margin accounts are unique because brokers have so much control over them. These controls allow the risk management methods to function but they can sometimes squeeze traders. A broker can force the sale of assets in an account to mitigate losses. This is the mechanism in place during a liquidation but it can extend beyond a single position. A broker might need to close multiple positions within an account or even shut the account down entirely if all the margin is used.
Most products have limited downside but certain situations with shorting and options create the opportunity for unlimited losses. In this instance, the losses could extend beyond the total margin in the portfolio and require another deposit just to break even.

Loss of Funds Greater Than Deposit

The most disastrous event in margin trading is the loss of funds that exceeds the value of the account’s deposits. This arises when a short position bears a massive counter-party obligation that the portfolio can no longer cover. Exchanges attempt to mitigate these events by constantly monitoring risk but markets can move quicker than the exchanges can liquidate positions.

Putting It All Together

These are the four most common risks associated with trading margin. Each one acts as a sort of warning that the following risk is imminent.

Looking Forward

That wraps up the margin series. Margin is a cornerstone of derivatives which makes a solid understanding of its mechanics paramount to success with trading. Next, we’ll dive into some basic derivatives concepts and frameworks. This will give you everything you need to understand a few common derivatives strategies.

Follow us to stay updated, or join the discord to get the alpha first.

As always, no marginfi content should ever be considered financial advice and no reference to financial assets, securities, derivatives, or other financial products should be considered an endorsement of the aforementioned. Please consult a licensed financial advisor before making any and all investment decisions, and please do your own research.

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Anders

Anders

recovering tradfi enthusiast | building @marginfi