The world of trading can be a daunting place, especially for those new to the game. The pressure to make the right decisions, coupled with the risks of losing money, can be overwhelming. However, for those who are looking to maximize their potential profits, margin trading can be a valuable tool. This article will tell you everything you need to know about margin trading.
What Is Margin Trading?
Margin trading is a financial method of engaging in trading activities using money borrowed from a third party. It allows traders to invest more money than they actually have by providing them with upfront capital to trade in the market. This capital is offered against their already-owned assets and securities, which act as collateral. In other words, it is like a loan that is specifically designed for trading purposes.
Compared to loans from banks or other lending institutions, margin trading allows traders to borrow money at a lower interest rate with less paperwork and negotiations. Margin trading, as a trading mechanism, has grown in popularity in recent years due to the potential of earning extraordinary profits. If a trader’s bet wins, they can book profits that are much higher than their initial investment. However, if the bet does not win, they will have to repay more than their initial borrowed capital, and interest is charged, which amplifies the losses incurred by the trader.
Risks Associated With Margin Trading
While margin trading can offer the potential for higher profits, it also comes with a higher level of risk. Traders who engage in margin trading must be aware of the potential risks involved and take appropriate measures to mitigate them.
One of the most significant risks associated with margin trading is the magnification of losses. As mentioned earlier, if a trader’s bet goes wrong, they can end up losing substantially more than they had initially invested. In contrast to spot trading, where traders can only lose the cash in hand, margin trading ensures that the trader is indebted to the broker.
Another risk associated with margin trading is the possibility of margin calls. A margin call occurs when the value of the equity locked as collateral falls below a certain value, and the broker demands additional funds or liquidation of assets to meet the collateral value. If the trader fails to comply with the margin call, the broker can sell the holdings to recoup the cash, and the trader may also face further penalties.
Furthermore, the collateral locked against the margin loan can be liquidated by the broker if the margin call isn’t met. The remaining part of the loan is viewed as an unsecured debt, which can adversely impact the trader’s credit score. It’s important to note that the risks associated with margin trading can also vary depending on the platform and the specific cryptocurrency being traded.
Regulations Around Margin Trading for US Citizens
As mentioned earlier, regulatory authorities in the USA have cut short exchanges from offering margin trading facilities. This has affected US citizens who have negligible means to leverage margin trading. In fact, only Futures Commission Merchants (FCMs) registered with the Commodity Futures Trading Commission (CFTC) are allowed to offer cryptocurrency derivatives and trading services under US Code: Title 7.
Coinbase Pro, a wing of popular crypto broker Coinbase, was offering margin trading services until late 2020 when they were instructed by the CFTC and their guidelines to immediately discontinue the margin trading product. Coinbase said that they are working with authorities to develop clear, sensible standards to safeguard and reassure US consumers.
The crypto industry in 2021 was far from idyllic, particularly for BitMEX, a P2P network for crypto goods that was forced by the US Federal Court to pay a $100 million penalty. The penalty was imposed because BitMEX provided derivatives and/or margin trading services to US persons in violation of the Commodity Exchange Act (CEA).
Aside from these cases, the CFTC has sanctioned 14 crypto players for providing derivatives and margin trading services. The CFTC contends that the $1.25 million fines on Kraken were “part of the CFTC’s broader effort to protect U.S. customers,” which is one of the fundamental aspects of these measures.
To add to the anguish, McDermott Will & Emery (MWE), a reputed law firm, expects more regulations in the crypto space. Apart from the CFTC and SEC, MWE also expects the Treasury and Office of the Comptroller of the Currency to wield influence over the nascent industry of crypto. Barring this, individual states also have their own laws regarding financial services.
While the recent past has been a nemesis for the margin trading sector of the crypto market, traders must adapt to the changing regulatory landscape. It is essential to understand the current regulatory environment around margin trading in the US before engaging in any such activity.
How to do Margin Trading in the United States
When it comes to margin trading in the USA, there is only one authorized and trustworthy platform – Kraken. Kraken is a US-based cryptocurrency exchange and bank that offers margin trading services to eligible users.
To be eligible for margin trading on Kraken, individual clients must have more than $10 million in invested assets, including cryptocurrencies, stocks, bonds, mutual funds, and real estate. Institutional clients represented by an ECP (Eligible Contract Participant) under US law must have more than $10 million in total assets.
Kraken offers margin trading on more than 35 cryptocurrencies, including blue-chip cryptos like Bitcoin, Ethereum, and Litecoin, among others. All of them can be traded in pairs either with BTC, USD, EUR, or ETH.
One of the key differences between Kraken and other margin trading platforms is that Kraken only allows 5x leverage for US citizens. Non-US users can enjoy futures with up to 50x leverage. The 1:5 leverage cap of Kraken is in substantial compliance with the regulators and provides safe yet profitable margin trading opportunities to US citizens.
Fees on margin trading on Kraken are extremely competitive and reasonable for the majority of the crypto population. Fees up to 0.02% shall be charged to open a margin position, and for every four hours of maintaining the ‘open’ position, a rollover fee of up to 0.02% will be charged.
Before using Kraken for margin trading, users must verify to the intermediate tier. Those with pro-tier verification will not be affected. Additionally, users outside the US must also verify to the intermediate tier to continue margin trading on Kraken.
While Kraken is the only authorized platform for margin trading in the US, it is important to note that only experienced investors who are comfortable with the risks should consider margin trading. Newer investors are likely better off using cash accounts to invest and learn about the market to start. It is also important to have enough cash on hand to cover potential losses if investments fall in value.
Advantages of Margin Trading
Margin trading offers several advantages to traders who are looking to increase their purchasing power and magnify their profits. Some of the main advantages of margin trading include:
- Greater purchasing power: With margin trading, traders can borrow funds to increase their purchasing power, which can allow them to take larger positions in the market. This can potentially result in greater profits if the trade is successful.
- Magnifies profits: Margin trading can also magnify profits, allowing traders to earn more money than they would with their own capital alone. This is because the profits are calculated based on the total value of the position, which includes the borrowed funds.
- Flexibility: Margin trading provides traders with greater flexibility, allowing them to take advantage of market opportunities as they arise. This can help traders to respond quickly to market changes and take advantage of short-term price movements.
Disadvantages of Margin Trading
While margin trading offers several benefits, it is also associated with some significant disadvantages that traders should carefully consider before engaging in this trading strategy.
One of the most significant disadvantages of margin trading is the interest charged by the broker for the borrowed funds. The interest rate is usually higher than the standard interest rate for other loans, and it can accumulate quickly, adding to the losses incurred by the trader if the trades do not go as expected.
Another significant disadvantage of margin trading is that it magnifies losses, meaning that if the trades do not go as planned, the losses can be significantly more significant than the amount initially invested. This can lead to traders owing more money than they can repay, resulting in a debt trap.
Furthermore, margin trading requires traders to maintain a minimum amount of equity in their accounts. If the value of the equity falls below the required amount, a margin call is triggered, requiring the trader to add funds or liquidate equity to meet the collateral value. This can lead to forced liquidation of assets at unfavorable prices, resulting in further losses.
Is Margin Trading Right for You?
Margin trading can be a powerful tool for experienced investors looking to maximize their profits, but it’s important to carefully consider the risks before diving in. If you’re new to trading or investing, it may be wise to start with a cash account and learn about the market before attempting to leverage your investments with margin trading.
Even for experienced investors, it’s crucial to have enough cash on hand to cover potential losses if investments fall in value. Margin trading can magnify losses as well as profits, so it’s important to be comfortable with the potential risks involved.
Additionally, it’s important to have a solid understanding of the market and the specific assets you’re trading. Margin trading requires quick decision-making and the ability to react to changes in the market, so it’s not a good fit for those who are easily overwhelmed or indecisive.
Bottomline
Regulatory bodies in the US have placed restrictions on margin trading, limiting the availability of this trading method to a select few authorized platforms, with Kraken being the only trustworthy platform for US traders. Investors should also be aware of state laws regarding financial services. Regardless, the importance of regulations in margin trading cannot be overstated, and traders should always prioritize caution and prudence when engaging in this trading method. By carefully considering the risks and their own experience level, investors can make informed decisions about whether margin trading is the right choice for them.
