Spot Trading vs Margin Trading

Spot Trading vs Margin Trading

2 years ago

Buying and selling crypto on margin — using borrowed money — can reap great rewards, but it can also mean steep losses.

Spot Trading vs Margin Trading

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The difference between spot trading and margin trading in cryptocurrencies comes down to the concept of risk versus reward.
The crypto market is generally far riskier than trading stocks, bonds, commodities, currencies, and most other markets. Even Bitcoin is so volatile that prices rising or falling 10% in a day is far from unusual.
That’s what you get with spot trading, which is pretty straightforward: You buy or sell an asset on an exchange outright — for cash, stablecoins, like Tether or USD Coin, or other cryptocurrencies (for example exchanging Ethereum directly for Bitcoin). Once you buy or sell, the deal is done and you own what you own.
Margin trading, by way of contrast, is more complex and far riskier, However, the potential rewards are far higher than spot trading. The scale of risk and reward in margin trading in crypto is usually between 2-100 times.

The reason is simple: You’re borrowing money — often stablecoins — to bet on the price of an asset rising or falling. If you’re right, great! You pay back the loan and keep a far larger profit than you could by betting only your own money.

However, if you’re wrong, you still owe the lender what you borrowed, plus the interest and the transaction fees.

What Is Spot Trading?

The basic rule of investing is “don’t bet more than you can afford to lose.” This rule is fairly easy to follow in the spot market.
In spot trading, you pay the exchange a trading fee — generally 0.1% to 2%, depending on which exchange you are using and how much you are investing, as whales get better rates. You also have to take care of taxes, if you make a profit.

Take this example: You buy one Bitcoin at $50,000. If the price goes up to $55,000, you are up 10%, i.e., a $5,000 profit. If BTC hits $45,000, you’re down 10% which means a loss of $5,000.

This risk can be mitigated by a stop-limit (or stop-loss) order, which tells the exchange to automatically buy or sell when a certain price is reached in order to lock in profits or limit losses.

Even if you don’t do that, you’ve still got a $45,000 Bitcoin, which can — and over time always has — gone back up.

What Is Margin Trading?

Margin trading is where you bet the house — literally in some cases.
Most cryptocurrency exchanges allow you to trade on a margin of up to 20x leverage, or 1:20 — although some exchanges go as high as 100x, or 1:100. At that latter rate, you can put up $100 and buy $10,000, borrowing $9,900 of it.

At 20x, you’re putting up 5% of the cost of the cryptocurrency you’re buying.

So, if you want to buy one Bitcoin at $50,000 on a margin of 20x, you put up $2,500 in collateral and borrow the remaining $47,500. If Bitcoin goes up 10% to $55,000, you will double your money, which gets you to a 100% profit. But if Bitcoin goes down 10% to $45,000, you will lose twice as much as you started with, which will be a 200% loss.
However, margin trading generally doesn’t work that way. Those lenders have no intention of letting you lose all that money (their money) as you may not be able to pay it back.

What Is a Margin Call?

What happens is you get hit with a margin call. That means if Bitcoin’s price drops to near $47,500 — close to losing your $2,500 collateral — you’ll be asked for more collateral, often very quickly if the price is dropping fast. If you don’t meet that margin call — either because you don’t have the funds or you don’t act quickly enough — your position gets liquidated.

That’s when the exchange automatically closes the position and sells your collateral to pay off the lenders, who want their principal back and the interest you owe them. The exchange also charges its trading fee.

So, well before Bitcoin hits $47,500, you’ve lost your whole $2,500. On March 12, 2020, Bitcoin suffered a “flash crash” dropping from $8,000 to $3,600 in just a few hours. Over the next 24 hours, more than $1 billion in long positions were liquidated.

Long Position vs Short Position

There’s another wrinkle in margin trading: You can use that margin to trade options, going long or short — meaning you are betting on the cryptocurrency’s price to go up (long) or down (short).

In many cases, these bets are made on margin.

When you hold a long position, you buy the coin/token. With a short position, you agree to sell a certain amount of crypto — for example, one Bitcoin — at a certain date but have not bought it yet. The goal is to be able to buy it cheaper than the amount the counterparty buyer has agreed to pay for it.

But unlike straight margin investing, going long or short can be used to reduce risk. The goal is to protect yourself when you’ve made a big bet on the price moving in one direction by hedging on margin with an option that pays off if you’ve bet wrong and the price goes the other way.

Hedging is widely used in all markets, not just crypto, to protect against big losses. Given the volatility, it’s even more important in crypto markets than in stocks.

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