Spot vs. Margin Trading
Last updated
Last updated
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The distinction between spot trading and margin trading in cryptocurrencies lies in the balance of risk versus reward. Crypto markets are generally riskier than trading stocks, bonds, commodities, currencies, and most other markets. Even Bitcoin's volatility can cause its price to fluctuate by 10% in a day, which isn't uncommon.
Spot trading is straightforward: You buy or sell an asset on an exchange outright—using cash, stablecoins like Tether or USD Coin, or other cryptocurrencies (e.g., exchanging Ethereum directly for Bitcoin). Once the transaction is complete, you own what you've bought or sold.
Margin trading, on the other hand, is more complex and considerably riskier. However, the potential rewards are much greater than those of spot trading, with the risk and reward scale in crypto margin trading typically ranging between 2-100 times.
The reason for this is simple: You're borrowing money—often stablecoins—to speculate on an asset's price increasing or decreasing. If your prediction is accurate, you can repay the loan and keep a significantly larger profit than you could by wagering only your own funds.
But if you're incorrect, you still have to repay the lender the borrowed amount, along with interest and transaction fees.
The fundamental principle of investing is "don't invest more than you can afford to lose." This guideline is relatively easy to follow in the spot market.
In spot trading, you pay the exchange a trading fee, typically ranging from 0.1% to 2%, depending on the exchange and your investment size, as larger investors usually receive better rates. You also need to account for taxes if you make a profit.
For instance, let's say you buy one Bitcoin at $50,000. If the price increases to $55,000, you've gained 10%, or a $5,000 profit. However, if BTC drops to $45,000, you've lost 10%, resulting in a $5,000 loss.
You can manage this risk using a stop-limit (or stop-loss) order, which instructs the exchange to automatically buy or sell when a specific price is reached, either to secure profits or minimize losses.
Even without taking this step, you still possess a $45,000 Bitcoin, which can—and historically always has—recovered in value over time.
Margin trading can involve taking significant risks, potentially wagering everything in some cases. Most cryptocurrency exchanges allow you to trade with up to 20x leverage, or 1:20, while some offer as high as 100x, or 1:100. With the latter rate, you can contribute $100 and purchase $10,000 worth, borrowing the remaining $9,900.
At 20x leverage, you're covering 5% of the cost of the cryptocurrency you're buying. For example, if you want to buy one Bitcoin at $50,000 with 20x leverage, you would provide $2,500 as collateral and borrow the remaining $47,500. If Bitcoin's value increases by 10% to $55,000, you would double your initial investment, resulting in a 100% profit. However, if Bitcoin's value drops by 10% to $45,000, you would lose twice your initial investment, amounting to a 200% loss.
Nonetheless, margin trading doesn't usually function in this way. Lenders have no intention of allowing you to lose all that money (which is their money), as you may not be able to repay it.
In margin trading, a margin call occurs when the value of your investment approaches the amount of your collateral. For example, if Bitcoin's price drops close to $47,500, nearly equaling your $2,500 collateral, you'll be asked to provide additional collateral, often quickly if the price is falling rapidly. If you fail to meet the margin call—due to insufficient funds or slow response—your position will be liquidated.
During liquidation, the exchange automatically closes your position and sells your collateral to repay the lenders, who want their principal and any interest owed to them. Additionally, the exchange charges its trading fee.
So, well before Bitcoin reaches $47,500, you've lost your entire $2,500 investment. On March 12, 2020, Bitcoin experienced a "flash crash," dropping from $8,000 to $3,600 in just a few hours. In the following 24 hours, over $1 billion in long positions were liquidated.
Margin trading also allows you to trade options by going long or short, meaning you bet on the cryptocurrency's price to rise (long) or fall (short). Often, these bets are made using margin.
When you hold a long position, you buy the coin/token. In a short position, you agree to sell a specific amount of crypto—for example, one Bitcoin—at a certain date but haven't purchased it yet. The goal is to buy it at a lower price than the agreed-upon amount for the counterparty buyer.
Unlike traditional margin investing, going long or short can help reduce risk. The objective is to protect yourself when making a significant bet on the price moving in one direction by hedging on margin with an option that pays off if the price moves in the opposite direction.
Hedging is a common practice across various markets, not just crypto, to guard against substantial losses. Due to the volatility of cryptocurrencies, hedging is even more crucial in crypto markets than in stock markets.
