Have you already gained some victories in trading, and are you currently seeking tools to boost your next trades? If so, margin trading might be the solution. While this method can mean amplified losses and present higher risks, it can also lead to greater profitability and portfolio diversification if used correctly.
This lesson will explain what margin trading is, as well as its advantages and disadvantages, to help you start continue your trading journey safely.
Read the following lessons for more beginner trading knowledge:
What is margin trading?
Margin trading is a trading approach in which a trader borrows funds from an exchange like Huobi Global to open positions that are larger than the balances of his account. Using third-party capital enables a trader to leverage their trades. For example, if a trader uses a 100:1 leverage on a 1,000 USD position, he will be managing a position worth 100,000 USD. Therefore, margin trading allows a trader to boost their trading results so they become even more profitable if successful.
Simply put, margin trading is a method of buying long and selling short, using borrowed funds as leverage. Typically, if a trader believes the price will go up, they will open a long position. If they predict a price decrease, they will do the opposite.
A trader must reserve a certain percentage of the total order value to open a margin position. Using the previous numbers as an example, if a trader wants to open a 100,000 USD position with a 100:1 leverage, he needs to deposit 1,000 USD to do so; this 1,000 USD functions as the margin.
The margin value depends on the amount of leverage used – the higher the leverage, the lower the requirement. So if a trader uses 2:1 leverage, the requirement is half the position’s value, compared to the prior 1/100. It’s important to remember that these assets function as collateral while the margin position is open, and if the position no longer fulfills margin requirements, the exchange may liquidate the position.
Advantages and disadvantages
There are three main advantages of margin trading:
1. It enables a trader to make significant profits with less capital. This also allows smaller investors to trade with big positions.
2. Margin trading can help diversify a portfolio, as only relatively small amount of capital is needed to open positions.
3. A margin account facilitates the speedy opening of positions quickly without traders needing to transfer large funds to their accounts, though this may be necessary in situations like a market crash.
There are three main disadvantages of margin trading:
1. Just as a correct prediction can lead to greater profits for traders, an incorrect prediction will result in greater losses for traders.
2. A trader can lose more than they initially invested.
3. Even small market movements can activate the liquidation of highly leveraged positions, and cause substantial losses.
It’s essential always to remember to use risk management strategies and protection tools, such as stop-limit orders, against potential losses when the market doesn’t go your way.