Imagine that you buy a $100,000 house in cash. If the housing market improves, you might flip your house for $110,000 in a year and make a $10,000 profit, representing a 10% return on investment (e.g. $10,000 / $100,000).
Next, suppose that you bought the same $100,000 house with a 30-year mortgage. You put $10,000 down and take out a $90,000 loan with a 4.2% interest rate. You pay $1,500 per month for two years and pay roughly $36,000 toward the loan. The housing market improves and you sell the house for $110,000. While you made the same $10,000 in profit, you’ve actually earned a 22% return on investment (e.g. $10,000 / $46,000).
The idea of increasing return on investment using borrowed capital is known as buying on margin in finance. Unlike the housing market, cryptocurrencies can move ten or 20 percent within minutes and prices are a lot more difficult to predict. This means that you could lose your entire investment, or more depending on your margin agreement.
Let’s take a closer look at how you can use the same concept of margin within the cryptocurrency market.
How Does Margin Trading Work?
Margin trading enables you to borrow money using your existing capital as collateral to buy cryptocurrencies. In exchange, you generally pay interest on the borrowed amount and the lender has the right to liquidate, or call-in, your position when they feel that their money is at risk. Margin calls will unwind your position and represent the biggest risk.
For example, an account with 4:1 leverage enables you to buy $100 worth of Bitcoin with $25 and a $75 loan. If the price of Bitcoin falls below a certain threshold, you could receive a margin call from your lender. You can either deposit capital to keep the position open or let the lender liquidate the position, take what they’re owed and provide you with the remainder.
You can use margin for long or short trades. For instance, you can bet that Bitcoin prices will fall by borrowing money to buy Bitcoin and immediately selling it. The idea is that you can repurchase the Bitcoin at a later date — when the price has presumably fallen — and realize a gain on the difference. You can also borrow money to amplify return on investment.
Where to Trade on Margin
There are many cryptocurrency exchanges that support margin trading, but they have different leverage amounts and requirements. Some exchanges require margin traders to meet strict criteria and others simply require that you have sufficient funds to cover the trade. You may also be required to sign a margin agreement outlining the risk and terms.
For example, Kraken provides traders with up to 5:1 leverage on cryptocurrency trades. Eligible clients can borrow up to $500,000 when placing trades and rollover fees are never more than 0.02% per four hours. The amount of margin available depends on the cryptocurrency pair that’s traded and there are both opening and rollover fees associated with these trades.
Many exchanges that permit margin trading, including Kraken, require collateral currencies. These fiat or cryptocurrencies that have an established value and robust liquidity, and typically include Bitcoin, Ethereum, U.S. Dollars, Euros, Canadian Dollars, and/or Japanese Yen. The idea is that there’s always a way for exchanges to collect if there’s margin call.
Should You Trade on Margin?
There are many different reasons that you may want to trade on margin. For example, trading on margin lets you commit less cash to a position and diversify into other investments or simply reduce your exposure to cryptocurrencies. The lower upfront cash investment also means that you will have higher ratios of returns to initial investments.
There are also many unique risks involved with trading on margin. While borrowed money may boost return on investment, you could also lose more than your initial investment. If you experience a margin call, you could have your position automatically liquidated and receive nothing in return — you could even owe more money on losses from the loan!
Beginners may want to shy away from margin trading until they have a better understanding of the risks and rewards. In fact, even many intermediate and advanced traders avoid margin trading because of these elevated risks. The risk of a temporary downturn wiping out a position is often greater than the benefit of using borrowed capital to amplify gains.
Short-term Trading on Margin
Many day traders and other short-term traders use margin accounts to capitalize on many small price movements rather than making large directional bets. For example, they may scalp a few points at a time and use margin to amplify those small gains and make the trades worthwhile. A 0.01% gain for the day could be worth 0.5% with a margin account.
In these cases, day traders tightly control risk for each trade in order to minimize the risk of a margin call. Since they’re only trying to make small gains, they are taking equally small risks. This means that margin doesn’t turn into the same kind of double-edged sword as it would for longer-term traders that are placing risky directional bets.
ZenLedger makes it easy to account for these small trades and stay on the right side of the IRS, including gains from margin accounts. By automatically importing crypto transactions across many exchanges, you can instantly calculate gains and losses and auto-fill popular tax forms like Form 8949 and Form 1040 Schedule D to ensure that you don’t miss anything.
Sign up today to simplify your Crypto Taxes and Accounting!
The Bottom Line
Margin trading enables you to borrow money using your existing capital as collateral to buy cryptocurrencies. By doing so, you can purchase more cryptocurrency than your account value, amplify your return on investment and diversify your risk. The catch is that losses are also amplified and it’s possible to lose more than your entire investment in a trade.
You should carefully weigh these benefits and drawbacks before signing up for a margin account in order to avoid taking on excessive risk in your portfolio!