Imagine this: you’re sitting at the blackjack table and the dealer throws you an ace. You’d love to increase your bet, but you’re a little short on cash. Luckily, your friend offers to spot you $50 and says you can pay him back later. Tempting, isn’t it? If the cards are dealt right, you can win big and pay your buddy back his $50 with profits to spare. But what if you lose? Not only will you be down your original bet, but you’ll still owe your friend $50. Borrowing money at the casino is like gambling on steroids: the stakes are high and your potential for profit is dramatically increased. Conversely, your risk is also increased.
Margin trading or trading on leverage is in simple terms borrowing funds to leverage your bet. You take extra risk for the chance of extra reward. Logically, this is something you primarily want to do when you think the odds are in your favor. I have written an article on the topic of leverage here: Leverage Trading. Smash or Pass?
In this article I want to shed some light on the concept of the inner workings of margin, so that you can get a better understanding of what actually happens when trading on margin, or in other words: Leverage.
An important thing to realize is this. Because you are borrowing money, you owe the money back along with any applicable fees, no matter what.
This brings us to the next point. You have to have enough funds to cover the bet you are taking. If you don’t have the funds, your position will automatically be closed, “liquidated” or “called in.” As, although the lender will let you use their money for a fee to margin trade, any money lost and any fees paid will come out of your funds. This is like the friend who let you borrow $50; “the lender is letting you borrow money, not have it to lose.”
Specifically, if your balance falls below the “Maintenance Margin Requirement (MMR)” due to the price going the opposite way that you bet on, the exchange will either start liquidating your assets to get its money back or will simply request the funds from you (in crypto it is almost always the former as most exchanges have an automated “liquidation engine”). This is called a “margin call” or liquidation.
TIP: A margin call can be offset by depositing more funds to the order book you have the margin in (ex. BTC/USD). When you deposit more funds, you increase your margin ratio and improve your call price. Keep in mind however, that those additional funds will now also be at risk!!!
In summary the concept here is: margin trading allows you to make bigger bets than you otherwise would at the cost of extra fees and extra risks. When you make a bet, you can use the lender’s money, but if the bet goes the wrong way, the funds come out of your pocket. You take all the risks (although if you ever can’t cover your margin call, exchanges typically have an insurance fund and will socialize losses between other margin traders as a last resort… the money must always come from somewhere).
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