Are you new to crypto derivatives trading? Not sure how you can use leverage to your advantage? Or how to avoid the nasty shock of being liquidated at short notice? Fear not! Read on how to find out about what is margin trading.
Margin trading is the concept of a trader using borrowed funds from an exchange to trade a financial asset. It is popular among traders because of its flexibility and the possibility of winning big while using relatively low amounts of capital.
How Does Margin Trading Work?
To fully understand how margin trading works, it is essential to grasp its main characteristics and the main terminology.
Its main characteristics are the ability to buy long and sell short and the widespread use of leverage. That is why margin trading draws speculators, arbitrageurs, and market makers as it caters to their trading needs. Imagine having $100 and using 5x leverage. This would allow you to trade a contract value of $500. Similarly, using 100x leverage, you could trade a contract value of $10,000.
The Main Terminologies of Margin Trading
Leverage: Leverage refers to the funds which you borrow from exchanges. It is essentially a loan from the exchange.
On Bybit, the leverage ratio on offer ranges from 1x (regular) to 100x. This is adjustable on the top right-hand side of the screen.
The higher the leverage used, the more significant potential the profits can be. Any leverage is effectively borrowed money from the exchange, and the initial margin (cash originally deposited) is held as collateral for this.
If a trader makes a profit, they will get back the original deposit and the winnings. It can be an attractive option as part of a trading strategy due to its low margin requirements, but although the potential is there for big profits, significant losses can happen too, so caution is advised.
Initial Margin: This is the number of funds required to open a position when margin trading.
For example: If you opened a position for $100, and you use 100x leverage, you would be able to trade a contract value of $10,000.
The amount of initial margin required depends on the leverage used, and the higher leverage a trader uses, the lower margin required.
Isolated Margin and Cross Margin:
Bybit adopts two margin systems – isolated margin and cross margin.
On Bybit, the cross margin is the default margin mode.
Cross margin uses all of a trader’s available balance to prevent liquidation.
If the equity of the trading pair in question is lower than the maintenance margin, the position will be liquidated.
If liquidation does occur, all the equity will be lost for that trading pair.
Isolated margin isolates the initial margin placed into a position from a trader’s available balance.
Therefore, if a position is liquidated, the maximum amount a trader could lose is the initial margin placed into a position.
Cross margin has a lower risk of liquidation than isolated margin and a lower margin requirement, but unlike isolated margin, it doesn’t have an option for adjustable leverage. The leverage in cross margin mode is determined by the position size and available margin.
However, traders who take higher leverage in isolated margin mode will see their positions have the higher potential of being liquidated.
Cross margin is often used when a trader is holding a position for a longer time or taking part in an arbitrage strategy. That is because this mode protects positions from short-term volatility in the market.
An isolated margin happens when a trader is taking a speculative position. That is because traders can easily adjust their position if the market moves in an unfavorable direction.
In isolated margin mode (in USDT contracts), traders can turn on the Auto-Margin-Replenishment (AMR) function in their position section. AMR allows traders to automatically add a margin to their positions to avoid liquidation. If turned on, AMR will occur when the margin level reaches the maintenance margin level.
Traders can switch between cross margin and isolated margin modes when they hold an active position. The only exception is when traders are holding hedged positions of a USDT contract. In this instance, you can’t switch between a cross margin and an isolated margin.
Order Cost: This is the total margin needed to open positions when placing an order in the ‘Order Confirmation’ window and ‘Assets’ tab and is calculated by adding the initial margin to a two-way taker’s fee.
Maintenance Margin: This is the minimum amount of funds required to keep a position open when trading. The base value is 0.5% for BTC and USDT, and 1% for ETH, EOS, and XRP, of the value of the position taken. As with the initial margin, the level of maintenance margin required increases as the maximum possible leverage decreases.
With our USDT contracts: If a 1 BTC long BTCUSDT position is taken with an initial margin of 100 USDT and 100x leverage, with the contract value of 10,000 USDT, the maintenance margin is 10,000 x 0.5% = 50 USDT. Therefore, if the position falls to 9950 USDT in value, then the position will be liquidated.
For our inverse contracts, since the BTC margin value in USD drops together when the price is lower, in this scenario, the liquidation price will be slightly higher than $9,950.
Risk Limit: This is used in our inverse contracts. Checking the risk limit can tell you the initial margin and maintenance margin required and the maximum leverage you can use for a position. Risk limit is used to reduce the possibility of liquidation in large positions.
Tiered Margin: This is used instead of the risk limit for our USDT contracts. The higher the position or order quantity, the higher the initial margin and maintenance margin rates. A fundamental difference to risk limit is that the user’s current tiered margin will be automatically adjusted and does not need to be done manually.
Liquidation Price: When the Mark Price hits the liquidation price, liquidation occurs. When this happens, the entire margin of a position will be lost. A stop-loss order can be set to avoid liquidation occurring. Our mutual insurance feature can also be activated to provide cover for any losses suffered from unexpected fluctuations in the market.
Bankruptcy Price: The bankruptcy price indicates that all of the initial margins of a position is lost. A liquidated position is closed at the bankruptcy price.
Stop-Loss: This can be set up as an exit order to limit the losses made in an existing open position. They can be set up (along with Take Profit) using the TP/SL function on Bybit. It can be used to prevent liquidations.
Long and Short Positions: These can both be used in margin trading. Traders take long positions when they think the price of an asset will increase and take short positions when they believe the price of an asset will plunge.
Benefits and Risks of Margin Trading
Typically, as with anything in life, there are benefits and risks that need to be considered when margin trading.
Benefits of Margin Trading
As already referred to, a major advantage of margin trading on Bybit is the possibility of using up to 100x leverage on positions, therefore possibly making significant gains while having traded only a small amount. This can be an excellent tool for shrewd investors looking to make big bucks fast.
An additional benefit is the relatively small amounts of capital needed to open a position allows traders to diversify their portfolio of investments by opening different positions.
Risks of Margin Trading
However, on the flip side comes risks. If the market goes against the way you expect, good times can turn sour, and you could be quickly liquidated, especially if using a large amount of leverage.
As crypto markets are notoriously volatile, it is recommended to approach margin trading with caution and have a well-grounded knowledge of trading and risk management before taking out highly leveraged positions. Also, that’s why it’s a good idea to place a stop-loss order to protect yourself against circumstances when the market doesn’t go your way.
The Bottom Line
Margin trading can prove to be a wise investment choice for a trader if done sensibly, and the risks are taken on board. However, it requires patience and some knowledge of trading to be done effectively. Big profits can be made using relatively low amounts of margin due to the money borrowed from the exchange (leverage).
But any trader needs to be aware of the risks involved too. Market conditions in cryptocurrency can change quickly, and volatility can strike fast. As a result, positions can be liquidated promptly, and trades can soon turn sideways, with large amounts of money lost, if traders are not careful.
When it comes to crypto trading and the process of investing in assets in general, the critical mantra ‘do your own research’ should be at the forefront of any traders’ mind. Depending on their goals, traders should think carefully if margin trading is right for them before committing to a trade.
It may be the right time, or you may decide you need more trading experience before getting into margin trading. Indeed, for most beginner traders, it may be wise to take baby steps before dipping your toes in margin trading. Of course, no matter what, only ever trade what you can afford to lose.
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