A definition of margin trading
Margin trading enables investors to purchase more assets by borrowing funds from a broker, rather than using their own funds. This strategy works similarly in cryptocurrency markets as in traditional markets, where margin funding is essentially a loan to trade a digital asset, with the margin representing the difference between the investment’s total value and the borrowed amount.
In margin trading, the assets held in the trading account serve as collateral for the loan to cover the credit risk and potential losses incurred by traders, particularly when trading on leverage. In the event of a significant drop in the investment’s value, the brokerage firm or crypto exchange may liquidate the trader’s assets.
To engage in margin trading with cryptocurrencies, an investor must first obtain authorization from the service provider to open a margin account and deposit crypto, cash, or securities as collateral for the loan. However, it’s worth noting that using leverage amplifies both profits and losses, and heavy losses can result in a margin call, such as a reduction in the equity value of the securities.
A margin call allows the exchange or broker to liquidate the investor’s collateral without consent or request additional funds to be deposited into the margin account to prevent a forced liquidation to satisfy the broker.
Article structure:
Explanation of margin trading
Margin trading enables experienced investors to potentially magnify gains quickly, but it can also lead to substantial losses if the trader is unfamiliar with its mechanics.
In margin trading, crypto investors borrow funds from a brokerage firm to engage in trades. Initially, they deposit cash into a margin account, which serves as collateral for the loan. Interest on the borrowed amount is paid either at the end of the loan or through periodic installments based on prevailing market conditions. Upon selling the asset, the profits are used to repay the margin loan first, with the purchased assets becoming the collateral for the loan.
Margin accounts are used for leveraged trading, where the leverage is the ratio of borrowed funds to the margin. For example, a $10,000 trade executed at a leverage of 10:1 would require $1,000 of the trader’s capital. The leverage ratio varies across trading platforms and markets, with ratios ranging from 2:1 to 125:1 in crypto margin trading.
Going long or short refers to a trader’s extended or negative position on an asset’s price. Amplifying gains is the primary benefit of margin trading, but traders risk losing money. The trader’s assets serve as collateral for the loan, and if their value falls below a set threshold, the broker may force a sale unless the trader injects more funds as collateral to meet the margin trading’s minimum requirements.
What exactly is futures trading?
Futures trading is a derivative contract between a buyer and a seller of cryptocurrency, which obligates them to execute the transaction at a predetermined price on a specific future date.
For some crypto enthusiasts, futures trading is a preferred investment method over the traditional process of buying and selling cryptocurrencies, as it eliminates the need for private keys, passwords, and other complicated trading platform procedures. Additionally, it provides exposure to the asset while mitigating the risk of loss from negative price changes.
Futures contracts are traded on futures exchanges such as the globally recognized CME Group and are identified by their expiration month. According to the Futures Industry Association (FIA), futures contracts’ trading volume reached 29 billion in 2021, with crypto futures trading gaining popularity among investors.
In futures trading, investors can hedge against price fluctuations in the underlying asset, which helps minimize losses from negative price movements. Hedging involves taking an opposite position to the one held in the underlying asset so that if the investor loses money on the latter, they can balance their risk exposures through futures contracts.
Although futures trading carries risks, the hedging element can reduce the potential loss, making it a less risky investment option than margin trading. However, investors still need to open a brokerage account and gain approval from the exchange or broker to start trading crypto futures.
How do futures trades operate?
Investors in the cryptocurrency market have the option of participating in futures trading, which allows them to speculate on the price of Bitcoin without actually owning the asset.
Crypto futures trading involves a contract between a seller and a buyer. The seller enters into the contract hoping to lock in a price for profit at a specific date in the future, while the buyer purchases the agreement as a hedge against paying higher prices if the asset increases in value.
The contract’s fulfillment is guaranteed by futures exchanges, which regulate the process regardless of the asset’s actual price at the future date. In the crypto trading world, futures contracts are often quarterly or perpetual.
Futures contracts must contain certain elements, including an expiration date, the contract value, leverage, and settlement type. The expiration date indicates when the futures contract will be settled based on predetermined conditions. The contract value refers to the amount of cryptocurrency that serves as the underlying asset covered in the contract. Some exchanges allow traders to borrow funds to increase their position size and potentially boost gains, which is referred to as leverage. Finally, settlement type can be in cryptocurrency, cash, or through a bank transfer.
In what ways are margin trading and futures trading comparable as investments?
Futures trading in the cryptocurrency market enables buyers and sellers to execute a transaction at a predetermined price on a specific future date through a derivative contract.
For many crypto enthusiasts, futures trading is a preferable investment method compared to buying and selling cryptocurrencies traditionally, as it eliminates the complexities of private keys, passwords, and other trading platform procedures. Additionally, it provides exposure to the asset while minimizing the risk of loss from negative price changes.
Futures contracts are traded on futures exchanges, including the globally recognized CME Group, and are identified by their expiration month. According to the Futures Industry Association (FIA), crypto futures trading gained popularity among investors, contributing to the 29 billion futures contracts traded in 2021.
Investors use futures trading to hedge against price fluctuations in the underlying asset, which helps minimize losses from negative price movements. Through hedging, investors can balance their risk exposures by taking an opposite position to the one held in the underlying asset.
Despite the risks associated with futures trading, the hedging element can reduce potential loss, making it a less risky investment option than margin trading. However, investors must still open a brokerage account and gain approval from the exchange or broker to start trading crypto futures.
Are margin and futures trading considered to be high-risk tools?
Investors are attracted to margin trading and futures for their potential returns, but they should be cautious and consider the risks before engaging in these types of trading.
Margin trading carries more risk than standard trading due to the leverage component, which can lead to greater losses than the initial investment. Because cryptocurrencies are highly volatile, investors may need to provide additional funds to avoid being forced to sell. Additionally, investors begin paying interest on the loan used to margin trade immediately, and this debt increases as interest accrues. As a result, margin trading is best suited for short-term investments, as the odds of making a profit decrease over time.
Good to know: DeFi and Web3: Breathtaking features that you don’t know
Futures trading also carries risk, primarily due to the elevated leverage that investors can request with their already speculative positions. Futures typically have much greater leverage than their underlying assets, which increases the risk of a margin call that could result in significant losses. The extreme volatility of the cryptocurrency market can further exacerbate this risk, as the price of a futures contract may not favor the investor at the contract’s expiry date.
Investors, particularly beginners with little knowledge of markets and trading strategies, should exercise caution and acquire trading skills before engaging in margin or futures trading, as both are speculative and risky investment tools.