The last paragraph was what prompted me to write this post.
“If you don’t know what you’re doing, do not mess around with margin trading and leverage.”
There’s simply far too many crypto investors who leverage but doesn’t utilize leverage properly.
Hence, we’ve set out to write an Ultimate Guide on Crypto Margin Trading. Our guide here will teach you the following:
- What Exactly is Margin Trading?
- Common Pitfalls for Crypto Margin Traders
- Best Exchanges for Crypto Margin Trading
What Exactly is Margin Trading?
Margin trading is a form of leverage, where essentially you are borrowing funds from external parties in order to increase your exposure into a particular investment.
For example, if an investor had 1 ETH and was interested in leveraging to increase their position further, they might consider putting down 1 ETH as collateral to receive a $500 USDC loan, which they would then use to invest into ETH again.
Assuming ETH was at $250, they would be able to afford 2 ETH, leaving them with a 3 ETH balance at the end of their trading session.
If ETH climbs $10 the next day and the investor sells, they would receive returns of $30 (3 ETH * $10), whereas if they had not leveraged, they would’ve only received returns of $10 (1 ETH * $10).
This is what we call a 3x leverage because the investor had increased his exposure three-folds, amplifying both their potential gains and losses by 3x.
Obviously in the example above, the outcome of the trade was favorable for the investor as the investor exited with a positive return on their investment.
If ETH had fallen instead and continued to fall even further, then a forced liquidation mechanism eventually occurs where the investor’s assets are automatically sold to the market in order to repay the lender.
Margin Trading Rules
Every exchange has their own trading rules when it comes to margin trading.
Binance, for example, allows a user to borrow on a 3:1 ratio, or 3x leverage. If you hold 1 BTC, you can borrow 2 BTC more.
If a user’s trading balance falls below the 3:1 ratio, a Margin Call is sent out to the user, which is a warning to inform the user that their investment is close to getting liquidated.
Once the user is below a 10:1 ratio, their assets are liquidated to repay the debts, which is equivalent to a 100% loss on investment.
On the other hand, another exchange may allow a user to borrow on 4x leverage, but liquidation happens at a 6:1 ratio. A 6:1 ratio would mean there’s less flexibility in how far down the price goes before the collateralized assets are force liquidated.
Generally speaking, the points below are the margin trading rules which are likely to differ between exchanges:
- Initial collateral – which is how much you need to have as collateral in order to borrow a specified amount
- Maximum collateral – or the bare minimum you must maintain as collateral to prevent a forced liquidation
- Liquidation Penalty – for centralized exchanges, you would normally lose 100% of your investment during a forced liquidation. However, for decentralized exchanges, a maximum collateral greater than 100% is generally required to borrow on margin, and a liquidation penalty could be charged on your over-collateralized balance
- Interest rate – the borrowing cost for trading on margin
- Expiration period – some exchanges impose a maximum period for how long you can open a position, others might have no expiration period
- Max slippage – applies only to decentralized exchanges and refers to whether a trade will actually go through if the initial price point you wanted to invest at has changed while your trade is still being processed on the blockchain
- Trading pairs – different exchanges have different trading pairs or tokens available for margin trading
Common Pitfalls for Crypto Margin Traders
As margin trading is inevitably a higher risk investment strategy, there are a couple of key things you should watch out for.
Below, I compiled a list of very common pitfalls that crypto margin traders fall into:
1. Low Liquidity and High Spread Exchanges
Regardless of what type of investment asset you’re looking at, liquidity is always going to be one of the most important factors to watch out for.
Anecdotally, I’ve noticed that retail investors pay A LOT less attention than professional traders and institutions when it comes to how liquid a particular asset is, whether it’s crypto or a more traditional investment asset like stocks.
When I ask my friends who work at hedge funds what the most important factor to watch out for is for investing in any type of assets, many of them say liquidity because if you can’t exit your position, it doesn’t matter how much you gain on paper.
Even if you can exit (most of the time you can), you’ll end up taking a big loss on the spread.
Let me give you a real example from a fairly popular decentralized platform – dYdX.
dYdX offers two trading pairs for leveraging ETH – in particular, the pairs are ETH/DAI and ETH/USDC.
This is what the order book looks like for the two trading pairs.