Leverage: the Difference between Spot and Margin Trading
Traders use different methodologies in different types of markets to make their trades, each with different risk and return potential. In this article, you will discover the differences between Margin Trading and Spot Trading and leverage.
What is spot trading?
In traditional finance, it is the market where financial instruments are traded for immediate delivery. In this case, the order to buy or sell is immediately followed by the actual exchange of the “real” instrument for cash, usually in fiat currency.
Any exchange or forex offers this type of market and service, in fact, no leverage or derivatives are used in this market.
The basic rule you often hear when approaching trading is “don’t spend more than you can afford to lose“. This rule is quite easy to follow in the Spot market as the capital that can be used is exactly the same as the capital that was previously deposited in the account in question. We will see that this is not the case in Margin trading.
The term spot trading is also used to refer to direct cryptocurrency trading.
Cryptocurrency trading on Spot markets simply takes the form of buying and selling the currencies themselves using your own balance.
The outcome of a Spot trade is straightforward:
- If the price of the purchased asset goes up, and then I sell, I profit
- If the price of the asset bought goes down, and then I sell, I lose.
- After I have sold the asset, if it goes up or down, nothing changes because I no longer have it.
However, different types of orders can be used on the cryptocurrency spot market.
The market order is the simplest one, whereby the sale or purchase is executed instantly, at the next available market price.
There are also limit orders and stop orders, which allow you to decide at what price to execute the currency conversion. Thus, only when the market for a pair reaches a certain price will the transaction be completed.
These complex orders are not derivative instruments, but simple functions made possible by the order book software.
Margin trading and leverage
On the margin market, it is possible to use leverage to move more capital than you actually have in your trading account.
A tool that a broker makes available to clients and which allows them to trade with a real value greater than the capital they actually have.
Most brokers allow their clients to trade on margin with leverage starting at x2 and going up to a maximum of x50 or even x100.
This means that with 100 Euros of margin and a leverage of x50 I can trade with 100×50 = 5000 Euros.
Essentially you are going to “borrow” from the broker the difference, i.e. €4900.
The multiplication allowed by leverage also applies to expected profits or losses. This is why leverage is rather risky: if you gain a lot, that’s great, but if you lose, you lose big.
Rationally you might be aware of this, but if you are susceptible to cognitive biases, you might feel that you are only risking a little because you have committed just a small percentage of the amount from your own pocket.
This is why the above-mentioned rule of “only spend what you are willing to lose” has to be seen from another perspective. In this case, you must first calculate how much you would actually lose, and then deduct how much you can spend.
If you use €100 of your balance and choose a leverage of x50, the position will be worth €5000.
If the price goes up by 2%, you will have a profit of: 2% x 50 = 100%, which equates to a net profit of €100 on our €100 of real capital, and you will eventually have €200.
If the price goes down, you will then have a loss of -100% on your original capital, and you will then have €0.
The liquidation risk in margin trading
Brokers, in order to protect themselves against losses, never allow a certain loss threshold to be exceeded. This would require the trader to pay back much more than they had borrowed, a sum they supposedly do not have.
For this reason, there is a safety threshold called the liquidation level which if reached triggers the automatic closure of the position. This means that the broker takes your margin.
This level is at a market price which is generally before the price at which you would lose your entire capital.
Returning to the example above, if the loss of 100% of your capital is due to a price drop of 2%, the liquidation could be triggered at e.g. 90% loss of capital, which corresponds to a price drop of 1.8%.
In spite of the safety threshold, the presence and conditions of which should be investigated in advance, margin trading is highly inadvisable for beginners and those without sufficient experience and positive results in trading on the spot market.
Even with this measure, in fact, losses can still be very high, especially with leverage above x25. In fact, the higher the leverage, the higher the costs in terms of fees and risks.
Higher fees are paid in the Margin market than in the Spot market, depending on a number of factors, such as the type of leverage and how long the position is held open. The longer a Margin position is held open, the more fees you will have to pay to the broker.
Margin trading: the meaning of Long and Short
In the Margin market, unlike the Spot market, traders can trade derivative instruments that allow them to profit from both upward and downward price movements.
This is possible for example through futures contracts between two parties in which one party chooses to profit from the growth of an asset, while the other will profit from the depreciation of the asset.
There are two terms widely used in industry jargon to refer to these two positions.
- Long – “going long” is the same as saying that you are “bullish” about the price of a cryptocurrency or asset. You believe that the price will go up and you make a trade to profit based on this assumption. In the spot market, going long means buying in the present moment, when you believe the market is at a low, in order to make a profit in the short to medium term.
- Short – on the contrary, going short means being bearish, so you trade with the view of the next price drop.
It is important to note that these trades are not made with a “real” cryptocurrency or asset, but with derivative instruments that follow the price of these underlyings.
To better understand what happens when you make these trades, we will talk below in terms of buying, selling and borrowing, but these are not direct transactions.
You trade via a financial derivative instrument, which in the examples below replicates the price of Bitcoin.
Without considering fees and leverage, let’s take two examples of short and long trades.
When you open a Long position, it is as if you borrowed from the broker e.g. 1 BTC, which at that moment is equivalent to 50,000 EUR.
You owe 1 BTC at that “frozen” price. You have 1BTC at your disposal.
If the price rises as expected, you close the position at e.g. €55,000. Closing the position is the same as selling 1BTC at the new price and returning the initial €50,000 to the broker. In this way you have earned €5000.
When you open a Short position, and you are therefore bearish on Bitcoin, it is as if you borrowed 1 BTC from the broker, which you immediately “sell” at the market price, e.g. €50,000.
You owe 1 BTC and have €50,000 to use.
If the price of BTC drops, say to 45.000€, and you close the position, you trigger a purchase at this price of 1 BTC.
The broker takes back 1BTC worth €45,000 and you are left with the difference of €5000.
If it goes wrong, and you close the position at €55,000, you lose €5,000.
In both cases, you have borrowed a financial product that corresponded to 1BTC, and you have returned the same amount borrowed, but you have gained on the change in value.
So let’s recap the differences between Spot trading and Margin trading: