What is margin trading?
Margin trading is a strategy that allows investors to buy more assets without using their own funds and borrowing funds from a broker instead.
Margin trading in cryptocurrency markets is no different from traditional margin trading. Margin funding is considered a loan to trade a digital asset, where the margin is the money borrowed from a broker and the difference between the total value of the investment and the loan amount.
The assets that form the balance of a margin trading account are used as collateral for the loan to cover the credit risk and potential losses traders may have, especially when trading on leverage. The brokerage firm or a crypto exchange may liquidate a trader’s assets if the value of the investment drops considerably.
In order to trade crypto with margin, an investor needs to be authorized by the service provider to open a margin account where to deposit crypto, cash, or securities as collateral for the loan. In margin trading cryptocurrency, the leverage will amplify both gains and losses, and a margin call may occur with heavy losses, such as a decrease in the securities’ equity value.
A margin call allows the exchange or a broker to liquidate the investor’s collateral without consent or to request more funds into their margin account to avoid a forced liquidation to satisfy the broker.
How does margin trading work?
Margin trading aims to amplify gains and allows experienced investors to potentially get them quickly. They may bring dramatic losses, too, if the trader doesn’t know how they work.
When trading on margin, crypto investors borrow money from a brokerage firm to trade. They first deposit cash into a margin account that will be used as collateral for the loan, a kind of security deposit.
Then they start paying interest on the borrowed money, which can be paid at the end of the loan or with monthly or weekly installments, based on current market conditions. When the asset is sold, proceeds are used to repay the margin loan first.
The loan is necessary to raise investors’ purchasing power and buy larger amounts of crypto assets, and the assets purchased automatically become the collateral for the margin loan.
The amount an investor is allowed to borrow depends on the price of the asset purchased and the collateral’s value. Still, typically a broker will offer an investor to borrow up to 50% of the purchase price of a cryptocurrency against the amount of collateral in the account.
So, for instance, if an investor wants to buy $1,000 worth of cryptocurrency and put half of that on margin, they’ll need at least $500 worth of collateral to repay the initial loan.
Margin trading leverage
A margin account is typically used for leveraged trading, with the leverage representing the ratio of borrowed funds to the margin. A margin trading example could be to open a $10,000 trade at a leverage of 10:1. In that case, a trader must commit $1,000 of their capital to execute the trade.
These leverage ratios vary depending on the trading platform and the market traded. The stock market, for example, has a typical ratio of 2:1. In contrast, with futures contracts, the ratio rises to 15:1. In crypto margin trading, where rules are not always established like in traditional markets, the leverage ratio could vary from 2:1 to as much as 125:1. The crypto community usually simplifies referring to the ratio as 2x, 5x, 125x, and so forth, which indicates the multiplied amount their investment could accrue to.
Margin trading includes references such as going long or short on trades investors take. When people go long, they refer to an extended position they’ve taken, predicting that the price will go up in value. A short position is based on the assumption that the opposite will happen, and investors have a negative position on the crypto, believing it will drop in price. In that case, the investor will profit if the asset falls.
The benefit of margin trading is to amplify gains, but investors can also lose money. The trader’s assets are the collateral for the loan, and in case their value drops below a fixed threshold, the broker reserves the right to force a sale unless the investor injects more funds as collateral to achieve the minimum requirements for margin trading.
What is futures trading?
Futures are a type of derivative contract that ties a buyer and a seller of a cryptocurrency to execute the deal at the established price at a specific date in the future.
Some crypto enthusiasts prefer to invest through futures trading instead of dealing with actually buying or selling it through private keys, passwords and generally avoid going through the hassle that most platforms require to trade crypto. At the same time, they have acquired exposure to the asset.
Crypto futures trading terms are indicated in a futures contract, which ties a buyer to receive a crypto asset at their predicted price on a specific date and the seller to deliver that asset at those same conditions when the futures contract expires, regardless of the market price at the expiration date.
Futures contracts are traded on futures exchanges like the CME Group, the largest and most recognized globally, and are identified by their expiration month. According to the Futures Industry Association (FIA), 29 billion futures contracts were traded in 2021. Futures trading cryptocurrency is a growing portion of the market, with more people interested in this type of investment.
CME reported an increase of 13% in Bitcoin (BTC) added daily value (ADV) of contracts and Micro Bitcoin futures traded in 2021. The benefits of futures trading mainly allow investors to hedge a crypto asset’s price movement to help avoid losses from negative price changes.
In hedging, investors take a position opposite to the one they hold with the underlying asset so that if they lose money on the latter, they will mitigate the loss through the futures contracts balancing their risk exposures and limiting themselves from any fluctuations in price.
You can lose money in futures trading. However, because of the hedging element, losses are mitigated and can be less dramatic than with margin trading. Like margin accounts, trading crypto with futures requires opening a brokerage account which must be approved by the exchange or the broker.
How does a futures trade work?
Futures trading in the cryptocurrency market allows investors to bet on the price of Bitcoin. For example, at a specific date in the future, all without actually owning any of it.
In crypto futures trading, a contract is ratified between a seller who wants to lock in a price hoping for a profit at a specific date in the future and a buyer who will purchase the agreement as a hedge against paying higher prices if the asset grows in value.
The process happens regardless of the actual price of the asset at that future date and is regulated by futures exchanges that must guarantee the fulfillment of the contract at its expiration date. With crypto trading, futures are often quarterly or perpetual contracts.
Futures contracts must include the following:
- An expiration date: when the futures contract is settled at the predetermined conditions;
- The contract value: the amount of cryptocurrency which forms the underlying asset covered in the contract;
- Leverage: Some exchanges allow traders to borrow funds to increase their position size and boost potential gains;
- Settlement type: it can usually be in cryptocurrency, cash in hand or through a bank transfer.
Are margin trading and futures similar investments?
Margin trading occurs in the spot market — a marketplace for immediate delivery — while futures relates to trades occurring in the derivatives market on assets to be delivered in the future.
Margin trading and futures trading are two strategies that require the investor to have good trading skills as they are considered advanced trading techniques. They are two different types of investment tools with a similar goal, but they just go about different ways to achieve it.
Margin trading vs. futures: Similarities
Margin trading and futures are similar investment tools. They aim to allow investors to buy more of a crypto asset using only their equity. They are both speculative instruments and have different approaches to achieving the same goal.
They can both trigger amplified returns but can cause extreme losses too. Especially in the highly volatile cryptocurrency market, it’s somehow easy to experience significant quick gains. Still, dramatic losses can occur too, so it is recommended that only experienced traders use these tools.
Margin trading vs. futures: Differences
The main difference between margin trading and futures is in the market they are traded. Margins are traded on the spot market, while futures are contracts exchanged in the derivatives market and imply the future delivery of the asset.
Margin trading in crypto usually has a leverage that ranges between 5 and 20%, while it’s common to exceed 100% in futures.
Crypto margin accounts allow traders to leverage the spot market through a sort of loan on which interest must be paid, while futures only require a good faith deposit as collateral.
Being perpetual, the spot market requires traders to determine how long they want to keep a coin leveraged. On the other hand, futures are contracts with an expiry date that determine how long you can hold a position.
Types of investors
They target two types of traders for executing margin trading and futures. Margin trading is more for short-term investors, while futures refers more to long-term investors.
Are margin and futures trading risky tools?
While investors find margin trading and futures very attractive because of their potential returns, they should be cautious and consider all the risks before adopting them.
Risks associated with margin trading
Crypto margin trading is riskier than standard trading because of the leverage component, which may lose the investor more money than they held initially. Especially considering that cryptocurrencies are very volatile and unpredictable assets, the investor may have to provide extra funds to the collateral to avoid being forced to sell.
Investors start paying interest on the loan they took up to margin trade from day one, and the debt increases as the interest accrues. For this reason, margin trading is suited for short-term investments, as with interest to pay over the long period, the odds of making a profit are slimmer.
Risks associated with futures trading
The main risk associated with futures trading is the elevated leverage that investors can request with their already speculative positions. Typically, futures are allowed far greater leverage than their underlying assets, meaning they also face an increased risk of a margin call that could stretch the losses.
Coupled with the extreme volatility of the cryptocurrency market, the price of a futures contract may not favor the investor at the expiry date. Above all, beginners with little knowledge of markets and strategies should acquire some trading skills before venturing into either margin or futures trading, as they are speculative and risky investment tools.