Margin trading lets traders buy and sell with assets provided by a third party. Traders use margin trading to increase their buying and selling power.
Margin trading lets traders buy and sell with assets provided by a third party. Trading on margin lets traders open positions larger than their account size, amplifying either the profit or loss made by the trader.
Margin trading lets you trade with more capital than you have in your account.
The funds for margin trading are provided by a third party.
Trading on margin makes it possible to profit from upward and downward price movements.
Margin trading has increased risks compared to typical investing.
If you trade cryptocurrency with any kind of regularity, chances are you’ve seen things like “margin trading” and “leverage” appear on exchange sites or community forums. If you’ve ever wondered what to do with those options, or are (justifiably) cautious about experimenting with margin trading, this Guide will demystify some of the lingo and help you better understand trading on margin.
Margin trading services differ from broker to broker or exchange to exchange. Even though most margin services have different rules, this can always be said:
Margin trading lets you trade with more capital than you have in your account.
Trading on margin opens up the opportunity for higher gains while increasing the risk to the trader’s personal funds. The risk comes from the potential for increased losses — the exact same amplification of profits applies to losses made on a margin trade. Novice traders can easily find themselves losing more than they bargained for by overextending their account in margin trades.
How does margin trading work?
As mentioned above, margin services all feature different rules. Below is a general outline of what usually occurs when you submit a margin trade:
You open a trade and select a level of leverage — using leverage tells the exchange you are accessing third party funds, and what fraction of your personal capital will back the trade — eg. a $300 trade at 3x leverage requires $100 of your funds to back the position.
When you submit the trade, the borrowed funds enter the market and either buy or sell the full cost of your trade. You now have an open position.
Later, you must close the trade, repaying the third-party funding used to open the trade.
If your trade went well, the third-party funding is paid back to its provider with a small amount of interest, and you keep the profit. If the trade didn’t go well, you’re on the hook to pay back the loss using your own funds.
Steps 1 and 2 happen automatically and almost instantly when you submit the opening trade.
Steps 3 and 4 also occur almost immediately once the closing trade is submitted.
If the margin service provides the full cost of the trade, your funds do not enter the market and remain in your account. They are, however, usually locked (can’t be used to buy or sell until the position is closed).
Margin Trading Example
Margin trading allows for increased profits if your trade goes well, because you capture all the extra profit you gained by having a larger position size.
Let’s put an example in numbers - say you have $100 to trade with. If you buy just $100 worth of an asset, and that asset’s price increases 10%, you can now sell for $110. $10 profit.
However, if you use margin to access $500 worth of an asset, that same 10% price increase means you can sell your position for $550. If the third party issued you the full cost of the trade, you owe them the full $500 of borrowed capital plus interest (and trading fees) — but that still leaves you with a $50 profit minus any interest* paid to maintain the position. Same trade, more profit.
*For example, Kraken.com charges a 0.01% rollover fee every 4 hours a BTC position remains open.
Each margin trade consists of at least two orders: one opening order and one closing order. When your opening order is filled, you are now holding a position. If you open a margin trade with a buy order, it must be closed with a sell order and vice versa.
Where do margin funds come from?
As mentioned above, the rules for margin trading can differ broadly from market to market. In traditional stock markets you might contact a broker to be able to trade on margin. In this case, the broker is the most likely source of the third-party funds. In some cryptocurrency exchanges, however, the third-party funds come from other traders who lend out their own cryptocurrencies.
In other exchanges, like Kraken.com, the exchange itself maintains a margin pool — a collection of funds that the exchange uses to open trades on your behalf. On some exchanges, trading on margin saves the trader from having to own either the base or quote currency of the trading pair — like BTC or USD in a BTC/USD market.
What is leverage?
Leverage is the mechanism that changes a regular buy or sell order into a margin trade. By using leverage, traders can access more funds than they personally possess. This creates an opportunity for them to amplify their gains and their losses, depending on the outcome of the trade.
Traders must leverage their balances to access and trade with margin funds. The amount of funding available depends on the factor of leverage the trader chooses. For example, a market might have up to 5x leverage available — selecting a leverage amount of 5 would increase the trader’s potential trade volume by a factor of 5.
In traditional markets, leverage is expressed as a ratio (eg. 5:1, 10:1, 100:1). This standard can still be found in cryptocurrency markets, though some crypto exchanges express leverage as a multiplier (eg. 2x, 5x, 10x).
"Trading with leverage" & "margin trading" are essentially synonymous, but leverage specifically refers to the method of collateralizing your funds to borrow more capital from a third party.
Leverage ratio formula
The funds available for a leveraged trade is equal to Your Funds x Leverage Level.
If a trader has $1000 in their account, using 2x leverage opens up a potential $2000 in margin funds, 3x allows for $3000, and so on. The table below shows the potential margin funds available for the same initial commitment of funds at different leverage levels:
Value of the Trader’s funds
2 x 1000
3 x 1000
4 x 1000
5 x 1000
10 x 1000
100 x 1000
The amount of funds you need to assign to a leveraged trade is equal to Total Cost / Leverage level.
If a trader knows they would like to open a $1000 position, they can use higher levels of leverage to commit less of their balances to the trade. In this scenario, the Total Cost of the trader’s position is $1000, and the funds they need to commit decreases with higher levels of leverage:
Amount of trader’s balances “locked”
A trader might decide to commit less funds to a leveraged trade so they can enter a wider variety of markets. A trader with a $1000 trading account could open two 5x positions in different markets, while still holding $600 to insulate their positions against opposing market movements. By using leverage in this way, a trader can increase their exposure to each market while only putting a fraction of their funds to work.
FYI: It IS possible to lose more money than the locked funds backing your position. Exchanges & brokers usually require you to maintain either a certain level of equity or "maintenance margin" in your account to keep positions open. When your position's losses are extreme enough, you may be liquidated. When this happens, your position is closed at market price and its losses are taken from your account.
Long vs short
As you may already know, trades can go in two directions: buy or sell.
Buying on margin is called a long position.
Selling on margin is called a short position.
In spot markets, buying an asset without using leverage is also considered going long, if the trader intends to sell again at a higher price. However, leverage must be used to open a margin position. In some markets, buying on margin can let you trade an asset without having to own it first. Using Kraken.com as an example again, it’s possible to hold bitcoin and open margin trades in ETH/USD. This is because Kraken recognizes fiat currencies as well as selected crypto currencies as acceptable for backing positions.
It is not possible to short without leverage. If you take margin out of the equation, selling an asset just to buy it back later still leaves you with the asset in your balances. While holding the asset you remain exposed to the market — that is, vulnerable to further changes in price.
Selling on margin lets you capitalize from the downward price movement because your market exposure (at least to the base currency) ends when the position is closed. You would remain exposed to the profit currency, typically the quote currency. If the quote currency is fiat (eg. USD, EUR) this is a non-issue, since most of the big fiat currencies are very stable (especially when compared to cryptocurrencies).
Margin trades often incur a steady fee while they remain open on top of the trading fees for both the opening and closing trades. Savvy traders make sure the cost to keep their positions open doesn’t nullify any profits they might take.
The objective of a long position is to buy an asset while the price is low, then sell it for a profit when the price of the asset rises.
The goal is to “Buy low, sell high”.
Profit on the position increases as the price of the asset rises.
Traders lose money on the position when the price falls below their opening price.
To open a long position, create a BUY order and select whichever level of leverage best fits your strategy and risk assessment. When you submit the order, third-party funds will be used to perform the trade, and your funds backing the trade will remain in your account.
Here’s an example of how to long bitcoin:
A trader sees the price of bitcoin (XBT) is $10,000 and believes the price is about to rise.
They open a leveraged buy order for 1 XBT at $10,000. They use 5x leverage, collateralizing $2000 of their own funds to back the trade.
Via this order, a third party provides $10,000 for the purchase of 1 XBT. The cost to the trader is now -$10,000.
The price of XBT rises to $10,500.
The trader submits a leveraged sell order for 1 XBT at $10,500.
The $10,000 is recovered for the third party and $500 remains from the sale.
The trader’s profit is $500 ($10,500 - $10,000 = $500), minus trading fees.
Trading on margin let’s traders take advantage of not only upward price movement, but downward as well. The objective of a short position is to sell while the price of an asset is high, then buy again when the price falls.
The goal is to “Sell high, buy low”.
Profit on the position increases as the price of the asset declines.
Traders lose money on the position when the price rises above their opening price.
You can short an asset by opening a leveraged sell order when the price is high, then submitting a leveraged buy order for the same volume when the price falls. Apply your same methods of risk assessment that you would to any position, regardless of direction.
Using “borrowed” or third-party funds lets traders immediately sell an asset at a high price. If the price falls, the trader closes their position by submitting a buy order to recoup the volume of the opening trade. Since the asset is now less expensive, the trader can recoup the volume at a lower cost, keeping the difference in cost between open and close as their profit.
Here’s an example of how to short bitcoin:
A trader sees the price of bitcoin (XBT) is $15,000 and believes the price is about to fall.
They open a leveraged sell order for 1 XBT at $15,000. They use 3x leverage, collateralizing $5000 of their own funds to back the trade.
Via this order, a third party provides 1 XBT to be sold immediately at $15,000. The cost to the trader is now -1 XBT.
The price of XBT falls to $14,500.
The trader submits a leveraged buy order for 1 XBT at $14,500.
The 1 XBT is returned to the third party at a lower cost.
The trader’s profit is $500 ($15,000 - $14,500 = 500), minus trading fees.
If you want to short bitcoin or other cryptocurrencies, you will need to join an exchange that offers margin trading, like Kraken.com.
Margin calls and liquidation
The benefit of margin trading is the trader’s ability to place orders larger than their account size, but the trade-off is an increase in risk that they take on in doing so. Margin trading increases the potential losses on a trade by a factor equal to the leverage level used. If you open multiple margin positions, your margin account becomes more collateralized, reducing the amount of opposing price movements your account can withstand. Traders with failing positions are at risk of receiving a margin call, having their positions liquidated, and the potential loss of their personally-held funds.
What is a margin call?
When margin positions fail to a certain point, the broker or exchange will issue a margin call. A margin call is a notification, typically an email (though historically an actual phone call), alerting the trader to close or partially close their positions to stave off liquidation. If time permits, traders can also deposit more funds to their margin account to delay a liquidation.
What is liquidation?
Liquidations are how the broker or exchange protects the third-party funds used in margin trading. Say a trader opens a $1000 position using $200 in their account to buy a share of stock in company A valued at $1000. If the share price falls to $800, selling it now would return the trader $0 of their original $200 collateral, as those funds are now required to satisfy the third party’s $1000 used to open the position. The third party requires $1000, which is repaid by selling the asset at $800 plus the $200 backing the position.
In this case, many exchanges will execute a liquidation - automatically and forcibly closing the position at market price in order to protect the exchange from loss. Any unrealized loss on the position - like the $200 example above - becomes realized, and the trader loses their money instead.
This is how inexperienced traders risk wiping their accounts. When losses are amplified, traders can potentially risk more than the amount of their funds actually backing the position. Using the example above, if markets moved quickly and a liquidation was unable to close the position before the stock price dropped to $700, the trader would now be down not only their $200 initial collateral but would also owe another $100 to the broker or exchange. This leaves the trader with a negative account balance — they owe $100. In many crypto markets, liquidations are automatic and efficient, but in traditional markets these negative account balances may occur more frequently.
Margin trading risk management
Many traders stick to the 1% Rule: only risk up to 1% of your account size on each trade.
Traders and institutions with huge trading accounts may risk even less per trade. This doesn’t necessarily mean only using 1% of your account size to trade — but to be diligent about closing your trades before you lose more than 1% of your account size.
For example: if you have $5000 in your trading account, using the 1% rule means that if your stop loss is triggered, you will lose 1% of your account ($50).
Beginner traders often risk way beyond 1% of their account size, exposing themselves to total ruin and potentially wiping their account. By limiting the amount you risk per trade (using stop losses and strict exit prices) you can endure longer losing streaks.
Traders use stop loss orders to close their positions at a price level where they believe their prediction will be proven wrong. They determine this price level through market analysis, usually by observing price charts.
Some traders also use position size calculators to quickly determine the maximum volume of their positions based on where they place their stop loss. You can find Google Sheets/Excel templates online, or create your own using the Google Sheets add-on Cryptofinance.
Is margin trading worth it?
For experienced traders, trading on margin gives the extra opportunity to capitalize on upward and downward price movements. Access to third party funds increases a trader’s buying and selling power, increasing the potential worth of those opportunities in turn. The trade-off is, of course, a heightened level of risk associated with each trade.
Traders who use margin should have experience analyzing markets and controlling the risk associated with each trade. Failing to do so is little more than gambling — without an effective system to protect against trading losses, margin trading can (and most likely will) ruin the unwary trader.
If you’re just starting out in crypto markets, check out our What is Day Trading? Guide to learn some of the basic precautions and practices needed to start trading actively.