Margin trading is a rather ambivalent trading tool: you can earn a lot with it and lose a lot. Therefore, there is a widespread opinion among traders that this trading method is suitable for more experienced market players, while newcomers are scared by the loan mechanics. However, as is the case with any exchange tool, it is essential to understand how it works, how you can reduce risks, and then it will seem effective and necessary. Read all about it in our article.
Margin trading and how it works
This asset trading method uses borrowed funds from a third party (broker or cryptocurrency exchange) to increase the funds that can be used. The bigger the funds, the bigger the potential profit, respectively.
Leverage is at the heart of everything. It is the ratio of the loan amount to the margin — the amount of the trader’s personal funds that must be invested for the deal to occur. For example, to open an order for $500 and take advantage of 5:1 leverage, you need to invest your $100.
The amount of personal funds on the margin balance directly affects the size of the deal that the user can open. In this case, the margin balance ensures the trader’s activity. The profit received by the client while trading goes to him in full, excluding trading fees and fees for using borrowed funds. However, the loss is also debited from the personal funds on the margin account.
Margin call and liquidation
Suppose a trader incurs losses, and the margin becomes less than the minimum. In that case, he receives a margin call — a requirement to deposit more funds to the margin account for the margin to rise again to the minimum level. Otherwise, all the trader’s assets are liquidated to cover losses. Of course, it is the most unpleasant scenario that should be avoided by monitoring the market situation, closing unprofitable positions, and promptly reacting to margin calls.
Types of margin trading
There are two types of margin:
- Isolated: a separate margin account with an individual margin level is opened for each trading pair. Margin call and liquidation of one account do not affect others.
- Cross margin: there is only one account where all margin assets are available, the margin level is general, margin call and liquidation affect all assets.
However, cross-margin has one significant advantage — since the margin account is general for all assets, the profit on one pair can compensate for the loss on the other and thus save the trader from margin call. It makes the cross margin more flexible than the isolated one.
Trigger order as a risk management tool
Monitoring the situation and timely response play a considerable role in margin trading and trading in general. Since it is impossible to monitor the exchange rate around the clock personally, a trigger order comes in handy. It is a pending exchange order that creates a market order to sell or buy a certain amount of an asset when its price reaches a certain level.
Thus, a trigger order can automatically close a losing position when its price goes down or buy an asset when its rate rises.
Conclusion
Margin trading can bring much higher profit than using only your own funds, but it is also associated with high risks. If you are aware of these risks and know how to minimize them, your chances of successful and safe trading increase significantly.
