Margin trading refers to the activity of using borrowed money from a brokerage to trade.
While the potential rewards can get high, there are some sizeable risks that investors need to contend with.
For instance, you want to buy $1,000 worth of Ethereum, but you only have $500 available. Using margin trading, you’d be able to borrow an extra $500, getting you to the total.
If your $1,000 in Ethereum grew in value to $1,500, you’d be able to liquidate it and return the $500 to the lender, leaving you with a gross profit of $500.
Obviously, the value of cryptocurrencies can go dramatically down as well as up. In a situation where the price of Ethereum slipped down by 50 percent, your lender would be able to get their $500 first before you can access funds, potentially leaving you with zero.
Long and Short Positions
Going long and going short relate to whether a trader thinks that a cryptocurrency is going to rise or fall in value.
Going “long” in general means that you believe the bitcoin or Ethereum you’ve bought will increase in value over time, through leveraging, this can magnify your gains (as well as increase your potential losses).
On the other hand, you might believe that one of these cryptocurrencies is going to experience a decline in value. As you guessed, this is where short positions come.
For instance, let’s suppose you think that bitcoin, trading at $5000, is going to fall in price. You sell your bitcoin for $5,000 and then buy it back when it falls to $4,000. The moment this transaction has been completed, this represents a gain of $1,000.
Risks on Margin Trading
The fact that many cryptocurrencies are so volatile means margin trading is only recommended if you’ve done your homework and have knowledge.
Losing your money while trading crypto can be frustrating enough without the borrowed fund of other investors coming into the equation.
The main risk to bear in mind is that you have the potential to lose your whole initial investment through margin trading, especially if your focus has been on altcoins with high volatility and low volume.
If one of your trades begins to lose money, your margin can be “called in.” For instance, suppose you’re trading with a ratio of 2:1, where each dollar you’re investing is matched by someone else. When the value falls by about 50 percent, your position would be liquidated in order to preserve the lender’s funds.
In general, margin trading should be considered as a short-term investment, not least because of the wild volatility that often grips the crypto market.
You should never invest more than you can afford to lose, and it’s always worth setting limits that will automatically pull you out of an investment whenever it slips below a specific level. In a similar fashion, setting profit targets also guarantees that you exit a trade at the optimal time.