In my earlier post Crypto risk management – part 1: introduction I gave a brief intro to some thoughts and financial instruments that might be useful when managing risk of owning cryptocurrency. In this second part I’ll introduce in more detail how margin trading with leverage works. In the next and third post, I will then explain how this can be used to hedge against risk.
Before reading further, please note that none of what I’m covering should be considered investment advice. In fact, you should definitely not put any money into crypto without having done an awful lot of research on your own.
Margin trading is different to exchange trading. With exchange trading you simply buy and sell an asset without any fuss.
Margin trading exist for three separate reasons. First, it’s a tool to increase the potential profit of a trade by taking some additional risk. Second, it’s the only tool that will let you go short on some asset (i.e. profit from a decline in price). Third, when used correctly, margin trading can be used to reduce custody risk when trading on a centralised exchange.
In the next post I will explain how the second and third use of margin trading can be used for effective risk management, as opposed to increasing the risk/reward. This is contrary to how most people think of margin trading!
First, I want to explain how these concepts work.
How margin trading works
With a margin trade, you only have to provide a margin of the actual volume that you want to trade with. For example, if you provide a margin of 2 ETH and want a leverage of 4:1, you’ll end up with a total volume of 8 ETH to trade with. The exchange will lend you the remaining 6 ETH for a small fee.
The reason why this is different from a traditional loan, is that only your own margin is at stake (if your trade is losing value). The exchange will automatically liquidate your trade when the losses equate to your margin, which guarantees that the exchange will get back their principal of 6 ETH.
Let’s take the above example. Margin M of 2 ETH and leverage L of 4, will give trade volume V of 8 ETH:
M * L = V.
A price increase C of 5% will give a return R of 0.4 ETH:
V * (1+C) = V + R
With leverage of 1 (no leverage) and trade volume of 2 ETH, the return would only be 0.1 ETH.
On the contrary, if you want to stop your margin loss S at 20%, the accepted price decline C would only be 5%:
S / L = C.
With leverage of 1 (no leverage), the accepted price decline is 20%.
As you can see, margin trading with leverage does not change how much of your margin you can lose, but rather how quickly you will lose it. So it’s important to understand the market in which you trade and configure your positions accordingly.
Long vs. short positions
When you open a long position, you provide some margin and with leverage are lent cash, immeditately buying a volume of assets. You close the position by selling the entire volume of assets at a higher price, automatically returning the volume of cash that the exchange lent you, but keeping the profit of assets you made on the trade.
When you open a short position, you provide some margin and with leverage are lent a volume of assets, immediately selling those for cash. You close the position by buying back the entire volume of asset at a lower price, automatically returning the volume of assets that the exchange lent you when the position was opened, but keeping the profit of cash you made on the trade.