Let’s say you feel very confident about a potential trade. You are so optimistic about it that you want to open a position using more money than you actually have in your pocket at the moment.
The easiest thing you can do is buy on margin (a.k.a. with leverage). This is a simple way to borrow the money you need to fund your trade. In this article, we’ll explain how this works and what happens when you win and lose trades like these.
How does a typical leveraged trade work?
Here’s a typical scenario. You want to buy $500 of ETH but only have $100. What you can do is put up $100 of your own money and use a margin trading order to borrow another $400 from the lenders’ market.
This increases your total buying power to $500: 5X your actual budget. You are now trading with 5X leverage. With Adara, doing this is as simple as choosing the “margin trading” option when placing an order.
Trading on margin requires a minimum amount of money, known as the minimum margin. The minimum margin works as collateral for your loan. If you make losing trades, you’ll have to pay your lenders out of your minimum margin.
Of course, you don’t just have to trade at your minimum margin. You can put up any amount of money you want. So long as you exceed the minimum, your initial margin — the amount of money you put up for a leveraged trade — can be 10%, 30%, 90%, etc of the leveraged amount. The choice is yours.
Winning and losing margin trades
Winning a leveraged trade can put you in a very advantageous position. Going back to the example above, imagine you had $100 and ETH was priced at $200. You didn’t make a margin order, buying 0.5 ETH.
After this, the price of an ETH token went all the way up to $300. Your 0.5 ETH are now worth $150, giving you a $50 profit. This isn’t bad at all in relative terms — but what if you make the same trade using 5X leverage?
Well, your buying power is now $500: good for 2.5 tokens. When ETH goes from $200 to $300, your position goes to $750, giving you $250 in profit.
In other words, this specific margin trade quintuples your profits. Given your budget of $100, this is an important psychological and practical victory. This is the best-case scenario in any margin trade: that things go as you expected and you win money.
Unfortunately, margin trading also has a downside.
Let’s go back to that same trade again and imagine you used 5X leverage to turn your $100 budget into $500 of buying power.
Since $400 of that money are borrowed, they’re not yours to lose. You can only lose $100: the amount of money you directly own.
The difference between your buying power and the amount of money you own is known as the liquidation value. It’s called that because once your position size gets there, it will be liquidated to make sure your creditors get their money back.
In this example, we can only lose $100 out of $500. This means that the liquidation value for our position is $400: a 20% reduction in total value.
In other words, losing 20% of your margin trade position while trading with 5X leverage will wipe out your entire budget for the trade. If you’re trading on 10X leverage, your liquidation value will be 10% below your entry price.
If you’re trading on 100X leverage, you’ll only be able to lose 1% on your trade before reaching liquidation value.
All of this can be a problem when you’re trading crypto: an asset class that’s known for its volatility.
When margin trading goes well, it multiplies your profits. When it doesn’t go well, it can completely wipe out, your budget. This means that this is a high-upside, high-risk instrument that can benefit or hurt you depending on your skill level.
Fortunately for you, we’ve made a free video series on managing trading risks. This series includes lessons on margin trading specifically and is available at no charge on Adara Academy website.
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