Crypto margin trading: How it works

For investors looking to maximize gains, margin trading offers an opportunity to leverage positions by borrowing funds to increase purchasing power. Although common in traditional finance, the strategy is relatively new to the crypto world. It can amplify potential returns, but it comes with significant risks.

In this guide, we’ll explore crypto margin trading, its pros and cons, and the crypto exchanges that offer these services.

What is margin trading?

Margin trading (also known as leverage trading or buying on margin) is a financial strategy in which investors borrow funds from a centralized exchange (CEX) to make larger trades than their available capital would permit. In other words, they use their assets as collateral for a loan. This approach can amplify both gains and losses, as profits or losses are calculated based on the total amount traded, not just the investor's original capital. That means if the market moves unfavorably, the collateral may be liquidated to cover the borrowed funds, which can result in significant losses.

How does crypto margin trading work?

Understanding how to leverage trade is crucial for deciding whether this strategy suits your risk tolerance and financial goals. Leverage refers to the ratio between the borrowed funds and the initial deposit, often expressed as 2x, 4x, 10x, etc. Higher leverage allows traders to control larger positions with a smaller amount of their own capital, potentially increasing both their returns and their risks.

For example, an investor with $1,000 might use 10x leverage to borrow an additional $9,000 from an exchange, allowing them to make a $10,000 trade. If the value of their trade increases by 10%, the investor gains $1,000, doubling their initial investment. However, if the market drops by 10%, the investor loses $1,000, wiping out their entire initial capital. If the loss continues beyond this point, the exchange may sell the collateral to recover the borrowed funds, leading to even greater losses.

Long vs. short positions

Traders use margin trading to speculate on market movements by opening either long or short positions:

• Long position: Traders usually take a long position when they expect the price of a cryptocurrency to rise. For example, they might borrow Bitcoin (BTC), hold it until its value increases, and then sell it to repay the loan and keep the profit. Long positions are the most common form of margin trading because they generally involve less risk than short positions.
• Short position: Traders take a short position when they anticipate a price drop. In this case, they borrow crypto from the exchange and immediately sell it at the current market price. If the price falls as expected, they buy back the crypto at a lower price, repay the loan, and pocket the difference as profit. Short positions are riskier because there is no limit to potential losses if the price unexpectedly rises, which could lead to significant financial losses.

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Advantages of margin trading

Margin trading can be particularly advantageous for short-term investors looking to capitalize on the frequent fluctuations in the crypto market. Understanding how leverage works is key to optimizing a trading strategy. Here are some benefits of margin trading crypto:

• Potential for higher gains: The profits from margin trading are directly linked to the amount of borrowed crypto; higher leverage can magnify gains. This potential for increased returns is a major draw for traders considering leverage.
• Enhanced purchasing power: By borrowing crypto from a centralized exchange, traders can increase their purchasing power, allowing them to execute larger trades and potentially achieve higher profits.
• Greater flexibility: Margin trading offers a range of options, including different leverage multiples, enabling traders to tailor their positions to align with their specific investment goals and risk tolerance.
• Self-reinforcing cycle: Experienced traders who know how to trade crypto with leverage, especially for long positions, may benefit from a self-reinforcing cycle. As prices rise, their collateral's value increases, allowing for even greater leverage and further trading opportunities.

Disadvantages of margin trading

While margin trading offers the potential for higher returns, it also presents significant risks that traders must understand to mitigate the downsides of using leverage. Key risks associated with margin trading include:

• Greater losses and margin calls: Although leverage can magnify gains, it also increases the potential for losses. If the value of a trader's collateral drops, a margin call may be triggered, requiring the trader to add funds to the account to maintain the required margin. Failing to meet a margin call can result in forced liquidations, where crypto assets are sold at a loss to cover the shortfall.
• Account fees and interest charges: Engaging in margin trading usually incurs costs. Centralized exchanges charge interest on borrowed crypto, and additional account fees may apply. These expenses can erode potential profits and should be factored into any trading strategy.
• Forced liquidations: Margin accounts require an initial deposit and a minimum balance, known as a maintenance margin. If a trader's collateral value falls below this threshold, the exchange may automatically liquidate assets to restore the required balance, often resulting in a significant loss.

How to get started with margin trading 

Before starting, make sure you understand market conditions and leverage mechanics and have a risk management plan to protect your investments. Once you feel ready to trade crypto with leverage, here are the steps to follow:

1. Open a margin account: Register for a margin account on a centralized cryptocurrency exchange. This account is separate from a regular trading account and requires completing a know-your-customer (KYC) verification process. Be aware that some exchanges restrict margin trading services to users from certain jurisdictions.
2. Secure borrowed funds: Review the exchange's margin trading page to see the available leverage options, typically ranging from 2x to 10x. The amount of leverage offered may depend on the value of the collateral in your margin account.
3. Place trades: With the margin account set up and leverage secured, you can open long or short positions based on your market predictions. A long position profits if the asset's price increases, while a short position profits from a price decrease.
4. Manage interest payments: Borrowed funds come with interest charges that must be paid according to the exchange’s schedule. Remember to factor these costs into your trading strategy and profit calculations.
5. Prepare for margin calls and liquidation: If the value of your collateral decreases significantly, the exchange may issue a margin call requiring you to deposit additional funds. If the collateral falls too low, the exchange may liquidate your assets to cover the borrowed amount, potentially resulting in losses. It's crucial to be aware of these risks and have a strategy in place to manage them.

Five popular crypto margin trading exchanges

Many CEXs offer margin trading, but it’s important to research the features and services of each exchange before deciding where to trade. Here are five of the best crypto margin trading exchanges (at the time of writing):

1. Binance: As the world's largest crypto exchange, Binance offers over 500 cryptocurrencies and multiple margin trading options. The platform is known for its strong security measures and requires strict KYC verification, making it a secure choice for qualified traders.
2. Coinbase: With over 1.3 million users, Coinbase is known for its careful selection of listed cryptocurrencies, ensuring that only reputable projects are available. The platform also offers margin accounts to qualified traders, emphasizing security and regulatory compliance.
3. Bybit: Bybit supports margin trading on more than 1,000 cryptocurrencies, with leverage options up to 100x. The platform is recognized for its user-friendly mobile app, top-notch customer support, and relatively low trading fees.
4. Kraken: Known for robust security measures, Kraken offers a wide range of cryptocurrencies and margin services. The platform is a preferred choice for security-focused traders, offering margin accounts with competitive terms.
5. KuCoin: Supporting over 700 cryptocurrencies, KuCoin is known for its competitive fees and advanced security features. However, KuCoin is not available to traders in the United States.

Balancing risk and reward with CoinTracker

Leverage trading on CEXs has introduced advanced financial tools to crypto traders that were once only accessible through registered stock brokers. However, it requires carefully managing margin accounts, especially for U.S. traders to stay compliant with Internal Revenue Service regulations.

Fortunately, CoinTracker makes crypto taxes easy with features like automatic DeFi and NFT detection. By syncing with all your digital wallets, CoinTracker accounts for every trade and generates a tax report in minutes. 

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.