First of all, margin trading means contracting DEBT.
Plain and simple, to go straight to the point and the danger of doing this type of trading if you don’t have the necessary experience to play the game.
Debt that one takes on for the purpose of investing. And it is a two-edged sword, because although it can make you earn a lot of money in case you come out favored, you can also lose all your money in the blink of an eye. Let’s see it this way, who lends you the money? The Exchange. Is the exchange willing to lose money for a transaction of yours? No way. So, who is going to lose the money if the trade goes wrong? Only you.
So, how and when is margin trading used? Let’s suppose you have an account in an exchange, Kraken, the sum of USD 5,000, the current price of BTC is USD 5,000. You think, firmly, you are convinced, that Bitcoin is going to rise to $6,000. So what you do is borrow another USD 5,000 from Kraken to be able to buy 2 BTC at USD 5,000 each, and when BTC is worth 6000, you sell them and earn USD 2,000, because you pay Kraken back the USD 5,000 he initially bought from you. In theory it is beautiful. Theories are always nicer than reality. This trade is called going long. In this trade Kraken is only interested in getting the cash back.
The counterpart to this is going short. You think, again, incredibly convinced, that BTC is going to go down to USD 4,000. The current price is USD 5,000 again, you have USD 5,000 in your account as well. So you borrow 2 BTC from Kraken, sell them once they are in your possession, and wait for BTC to drop that $1,000 per coin you so desperately need. It does, you buy back BTC, give Kraken 2 back, and you’re left with a profit of $2,000. Again, this business works wonders.
There is another important concept which is leverage in this, Kraken offers leverage between 2x and 5x on many of its peers.
Leverage serves to get a larger return, but it also increases risk. If I choose a 5x leverage, it means that only one-fifth of my assets will be held as collateral for Kraken. The rest I can use to make other trades, but the position of the first trade will be weakened by the very high leverage I set.
So then, the problem is, what happens when the position starts to lose its value? If Bitcoin drops, if you played it long, or Bitcoin sky-rocket and you played it short? Your funds will start to lose its certainty, because if it gets too close to not being able te refund Kraken, Kraken will automatically liquidate your position without asking you. There is something previous to the liquidation, that is called margin call, where you’re allowed to deposit more funds in order to maintain the position, but if you fail to do, Kraken will execute the order, get their money back, and you won’t have much to say.
Finally, there are ways to reduce the risks in margin trading, which is by setting stop loss orders. As its name indicates, they stop losses before the biggest losses are executed, but this will be left for another post.
The important thing here is not to use margin trading if you don’t know what you are doing!
