One of the biggest dilemmas for traders of stocks, currencies, or cryptocurrencies is the choice between Spot trading and Margin trading. This decision will have to be made by each trader based on their preferences in terms of volatility and the amount of funds being traded.
In spot trading, you buy or sell an asset directly on an exchange, where you receive cash, stable coins, or other assets or cryptocurrencies (for example, exchanging Ethereum directly for Bitcoin). When you buy or sell the asset, the deal is completed and you become the owner of what you have.
Contrastingly, margin trading is a little more complicated and much riskier but potentially much more profitable than spot trading.
The risk-reward ratio in crypto margin trading is usually between 2 and 100 times. Roughly speaking, this means that every movement of the asset will be 2 to 100 times larger for a margin trader.
The reason is simple; you borrow money, often stable coins, to bet on the rise or fall of the asset’s price. If you are right, great! You will pay back the loan and keep a much larger profit than you could if you had only bet your own money. In the case of being wrong, you still owe the lender what you borrowed, along with interest and transaction costs.
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Spot Trading
The basic rule of investing is “don’t bet more than you are willing to lose.” This rule is relatively easy to follow in spot trading. For example: you buy one Bitcoin for $20,000. If the price rises to $22,000, you are in profit by 10%, or $2,000.
If Bitcoin falls to $18,000, your investment will drop by 10%, or a loss of $2,000. This risk can be mitigated by using a stop-limit (or stop-loss) order, which tells the exchange to automatically buy or sell when a certain price is reached, thereby securing a profit or limiting a loss. Even if you don’t do this, you still have $18,000 worth of Bitcoin, which may rise again over time.
In summary, when you buy an asset on the spot market, you are investing in the actual asset and not in some kind of contract (as is the case with margin trading).
Image: When you buy an asset in the spot market, you are investing in an actual asset, not some type of contract (as is the case with margin trading).
Another important difference between spot trading is that you can only trade with your own capital and there is no borrowing of funds involved. So, what you invest in your investment or trading account is what you have access to and that’s it.
Advantages | Disadvantages |
Lower risk | More challenging for traders with smaller accounts to achieve profits |
Good for beginners | |
Direct asset ownership |
Margin Trading
Margin trading is a type of trading where you pledge collateral (in some cases literally). Most cryptocurrency exchanges allow you to trade on margin with up to a 20x financial leverage, or margin, or 1:20. There are also exchanges that offer a 100x leverage, or 1:100. With 100x leverage, you can invest $100 and buy $10,000 worth of an asset, borrowing $9,900.
So, if you want to buy one Bitcoin for $20,000 with a 20x leverage, you put down $1,000 as collateral and borrow an additional $19,000. If Bitcoin rises by 10% to $22,000, you double your money, resulting in a 100% profit or $1,000.
On the other hand, if Bitcoin falls by 10% to $19,000, you lose twice as much as you started with, which means a 200% loss or $2,000.
However, margin trading does not usually work this way; lenders (exchanges) do not intend for you to lose all this money (their money) as you may not be able to pay it back. That’s where the “margin call” comes in.
What is a Margin Call?
If you are approaching the price where you will lose the collateral you have pledged (in our example $1,000), you will receive a margin call from the exchange. They will ask you for more collateral, often very quickly, especially if the price is falling rapidly. If you do not meet this margin call, i.e. if you do not have the funds or do not act fast enough, your position will be liquidated. In the case of a position liquidation, the exchange will automatically close your position and sell your collateral to pay back the lenders who want their principal and interest back. So, before Bitcoin reaches $19,500, you will have lost the full $1,000. On March 12, 2020, Bitcoin experienced a “flash crash,” where it fell from $8,000 to $3,600 in just a few hours. In this event, over a billion dollars worth of “long” positions were liquidated.
Advantages | Disadvantages |
Freedom in tranding in multiple markets | Higher commissions |
Advantages for experienced traders | Harder to understand for beginners |
Access to more capital | Quick, unexpected losses for beginners |
Long and short positions
When we have a “long” position open, we buy a coin and own it. With a “short” position, you agree to sell a certain amount of currency on a certain date, but you have not yet bought it. The goal of this is to be able to buy it cheaper than the amount the opposing buyer is willing to pay.
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