What is leverage?
When you trade on margin, you are enabled to open positions with the use of leverage. Through leverage you are able to invest a smaller amount of funds in order to open a larger position on the market. Leverage is usually presented as a ratio – for example, 1:2 or 1:5. What this relation means is that for every $1 you deposit into your trading account, you are able to open trades worth $2, or $5. With leverage of 1:5, if you open a $10 000 position in Bitcoin, only one fifth of that amount ($2 000) represents your own money. The remaining $8 000 will be borrowed.
We can say that the existence of a lending market facilitates margin trading. This is especially valid, when you trade Bitcoins directly, on a crypto exchange. You can borrow funds either from other users, or from the exchange itself, and will need to pay interest on such loans. On exchanges such as Poloniex, any user is able to lend Bitcoins or other digital currency and receive interest as benefit.
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Let us explain the concept of leverage in another way. If you deposit $2 000 into your account, with leverage of 1:5 you will be able to open a trade up to the amount of $10 000. If this trade generates a 5% return ($500), your account balance will actually increase by 25% (to $2 500). Or, we can say that leverage amplifies your potential for profit. However, it also increases your risk exposure. In the example above, if the result from the trade was a 5% loss, you would have actually lost 25% of your account balance. This is why leverage is often considered as a double edged sword. Leveraged positions should be traded in a short term with strict money management applied.
Terms related to margin
When it comes to margin trading, there are several key terms that require clarification.
It represents an account opened with a brokerage company, where the latter lends you money for trading purposes. Such a loan uses cash or other assets as collateral. As you operate with the brokerage company’s money rather your own, this creates leverage.
When you open a position on the market, a particular amount of funds from your account balance will be tied to that position. Such an amount is simply referred to as ”margin”. Note that it will not reduce your account balance. Instead, you will not be able to use that amount when making other trades. Since all the funds you use for your trade are actually borrowed from the brokerage, the margin serves as a sort of collateral for the loan.
The initial margin represents the amount of funds, which you need to ensure in order to make a trade, and depends on the leverage ratio.
If, for example, you employ leverage of 1:1 to buy Bitcoins worth $50 000, the initial margin will be equal to the total value of the position – $50 000. Thus, you need to provide the entire amount yourself. If you employ leverage of 1:2, the initial margin will be equal to 50% of the total value of the position, or $25 000. Thus, you provide $25 000 of your own funds and borrow $25 000. And, if you employ leverage of 1:5, the initial margin will be one fifth of the position, or $10 000. Thus, you provide $10 000 of your own funds and borrow $40 000. The initial margin refers to the amount of funds you deposit with a brokerage in order to begin trading on margin. It is also referred to as a ”good faith deposit”.
Used and Free Margin
The used margin represents the total amount of margin, which is tied to all your active positions. If you have four active positions with margins of $1 200, $350, $500 and $750 respectively, then the used margin will be $2 800 ($1 200 + $350 + $500 + $750).
The free margin represents the amount of your account balance, which is currently available to open new positions. It equals your total equity (initial deposit with profits added and losses subtracted) minus your used margin. If you have $12 500 in equity and $2 800 in used margin, then your free margin will be $9 700 ($12 500 – $2 800). Or, you will be able to open new positions, which require margin of up to $9 700. If the new positions require a larger margin, your orders will be cancelled automatically.
It is a ratio reflecting your equity compared to your used margin. It is presented as percentage and calculated as follows:
Margin Level = (Equity ÷ Used Margin) x 100
If you have $12 500 in equity and $2 800 in used margin, then your margin level will be 446%. Note that if the ratio drops to 100%, you will be unable to make new trades. If the ratio drops even more, some of the active positions you are holding will be automatically closed.
If the margin level is nearing 100%, you can either increase your equity (by depositing additional funds into your account), or reduce your used margin (by closing some of your active positions).
Maintenance Margin and Margin Call
The maintenance margin represents the lowest amount of equity, which you are allowed to have in your account in order to avoid margin call. For example, the maintenance margin will be 80% of your used margin, in case the margin call level is 80%.
The margin call level refers to a margin level, at which some of your active positions will be automatically closed. The positions will usually be closed in the order they were opened. In order for your margin level to move back above 100%, you may have several or all of your active positions closed. This way the brokerage makes sure that you will repay the amount borrowed with the value of your positions and your account balance. The margin call level usually depends on volatility of the respective trading instrument. Generally, it may correspond to a margin level of 70%-80%.
Let us consider the following example. You decide to deposit $10 000 and intend to open three short positions in Bitcoin with a total value of $20 000. Since you use leverage of 1:5, your margin will be one fifth of the total value of the positions, or $4 000. Your margin level after you open the positions will be ($10 000 ÷ $4 000) x 100 = 250%.
However, since you are trading against the underlying trend, once its next leg begins, you find yourself with a total loss on the three positions of $7 500. Thus, your equity will shrink to $2 500 ($10 000 – $7 500). Now, your margin level will be ($2 500 ÷ $4 000) x 100 = 62.5%. As a result, a margin call situation occurs and in order to bring your margin level back above the maintenance margin (80%), your positions will be closed automatically and you will have to deposit additional funds into your account. Since a margin call level of 80% corresponds to a minimum equity of $3 200 in your case, you will have to deposit additional $700 or more ($3 200 – $2 500) to meet your obligation.
Costs in Margin Trading
Beside interest paid to lenders, you will be charged a fee every time you open a position (opening fee) as well as a rollover fee (a fee for holding a position, which will be charged per certain period of time). These fees may vary depending on what cryptocurrency you have chosen to trade.