What Is Margin Trading?

2023/02/28 06:12

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Margin Trading Guide

Core difference between margin trading and spot trading

What differentiates margin trading from spot trading is the former allows borrowing to trade.

In traditional spot trading, the only way to make profits is by buying at low prices and selling at high prices amid an upward-trending market. Traders have two more ways to make profits in margin trading.

1. Short: Traders can borrow to sell at high prices first and buy back at low when the market goes downhill.

2. Amplify earnings: With borrowed funds, traders can scale their profits by much higher amounts than their own assets can offer in the buy-low-sell-high trades.

Assets, debts, and risk exposure

When a trader gains exposure to a certain cryptocurrency, their portfolio value changes along with the price fluctuation of this cryptocurrency. When a long exposure to a certain token is established, the portfolio value will increase when the token price rises and decrease when the token price falls. With a short exposure to a certain token, the portfolio value moves in opposite directions of the token price.

When a trader has borrowed a certain token, both their assets and debts increase and the net exposure is zero as the amount of the assets equals the amount of the debts.

If the borrowed token is sold for another token, the long exposure to the token becomes less than the short exposure. In this case, this trader's net exposure to this token is short, or this trader is going short on this token.

A net asset position grants a trader long exposure, while a net debt position grants a trader short exposure.

For example,

Alice owns an asset of 1,000 USDT and holds 1 borrowed ETH. Her asset and debt balances are as follows:

Asset Name	Asset Balance	Debt Balance	Net Exposure
USDT	1,000	0	1,000
ETH	1	1	0

Since Alice's net exposure to ETH is zero,ETH’s price changes does not affect the value of her portfolio.

Now Alice has sold 0.5 ETH for 500 USDT at the price of 1 ETC = 1,000 USDT. Then her asset portfolio is as listed in the following table:

Asset Name	Asset balance	Debt balance	Net exposure
USDT	1500	0	1500
ETH	0.5	1	-0.5

Alice now has 0.5 ETH in assets and 1 ETH in debt, making her net asset in ETH at -0.5 ETH, or she is shorting 0.5 ETH. Assuming the ETH price declines by 100 USDT, the number of ETH Alice owes is unchanged while its value is now lower(0.5 ETH * (1000-100) = 450 USDT). Thus the value of her debt has been reduced by 50 USDT, or her floating profit is a positive 50 USDT. Vice versa, if the ETH price rises by 100 USDT, then Alice would realize a floating loss of 50 USDT.

A portfolio with long exposure to a token profits from the rising price, while a portfolio with short exposure to a token profits from the falling price.

Relationship between value change of assets and debt and investment return

The price of a certain currency changes over time, and so do the value of the asset and debt in this currency.

But in some cases, the value of debt may change or stay static.

1. If a trader has borrowed stablecoins such as USDT, then the debt value doesn't change against USD.

2. If a trader has borrowed a non-stablecoin token, then the debt value changes along with the token price fluctuation.

For instance, if Alice has borrowed 3 BTC and the conversion rate is 1 BTC = 10,000 USDT. Then the debt value is 3 BTC * 10,000 USDT = 30,000 USDT. If the BTC price rises to 20,000 USDT, then the debt will also increase to 60,000 USDT = 3 BTC * 20,000 USDT. If the BTC price drops to 5,000 USDT, then the debt value shrinks to 15,000 USDT = 3 BTC * 5,000 USDT.

If Alice has sold BTC for USDT, then her asset value wouldn't change as USDT is a type of stablecoin that doesn't have price fluctuations. The debt is still measured in BTC, and Alice profits when the debt value depreciates and loses when the debt value appreciates.

If Alice has further traded the USDT asset for the ETH asset, then Alice's portfolio value would rise as the ETH price rises and the BTC price declines, and decline as the ETH price declines and the BTC price rises.

The relative valuation changes of the assets (long exposure) and the debts (short exposure) determine the traders' investment returns.