Margin Trading: What You Don't Think About Today Will Bite You Hard Tomorrow

How many chats on your phone are discussing where the Bitcoin price is heading right now? Even if you only touch the crypto industry with your left pinky, the Bitcoin price talk is hard to miss. Add to this the stories about someone who always seems to forecast the price right. A friend of a friend who moved to Bali and now makes a ton of money by trading straight out of his pool. The wizard sees in the price charts what others don’t see and makes profits when the markets are good, bad, and even ugly. 

Trading appeals by its promise of independence - do it from anywhere you want and whenever you want. Margin trading (the use of leverage) adds an extra edge - you can go big starting with little. With the magnitude of Bitcoin price moves and the leverage available as high as 100x, it becomes hard to leave the potentials of cryptocurrency margin trading unnoticed, at least in theory. From the dream of securing the bag while living on an exotic island to an idea of becoming a cool cryptotrader - margin trading can be a magnet to a diverse group of people. Reserved to professionals in white pressed shirts in traditional markets, margin trading in cryptocurrencies is available to almost everyone. Though democratizing financial instruments is a nice step towards more open finance, there is a flip side of this availability - we jump into something new and then wing it until we figure out how things work later. The cost of this “winging” are losses that could have been avoided. 

This post is not about the risks of trading with leverage. If you are reading this, likely you understand that leverage works both ways. It can shoot your gains up on a rocketship and it can also eat your deposit like a hungry bodybuilder on a competition prep. What happens is determined by the direction of the price movement. 

But there are aspects of margin trading more nuanced than the formula for gains or losses. Most people do not think about them, until their deposit is liquidated. 

In this post, we’ll go through the key aspects of margin trading that can bite you (and your profits) hard unless you pay attention to them. Good news - each of those aspects starts with “L”, and knowing them will help you avoid catching your own Ls in margin trading. Understanding them, you will be able to judge any margin trading platform more scrupulously than your girlfriend judges your ex. 

So let’s dive in:

Leverage

“Oh, leverage I already know!” - you’d say. That’s right, but let’s look deeper! Which instrument is this leverage provided with?

Not all margin trading platforms are created the same. The size of leverage is the simplest thing that differentiates them. Yet the type of instrument that provides the leverage on each platform affects a lot of things in your trading.

For example, users trade perpetual futures on BitMEX. Options were recently added to OKEx. CEX.IO Broker offers margin trading based on CFDs (Contracts for Difference). All instruments are traded with leverage, but all are different and represent different rights and liabilities of the parties involved. More so, the type of instrument determines what reference price your profit or loss is calculated against. 

Here’s what it means:

When you open a leveraged position with BitMEX futures - you buy from or sell to some other participant on this derivative market. Who those other participants - you don’t know. And there is no matching order of the same size that goes out to the spot market for execution. The gains and losses of your position are calculated against the price, which represents a weighted average index of prices on other exchanges.

In contrast, when you place an order with CFDs on CEX.IO Broker, the Broker is an intermediary of every transaction. The Broker quotes you the best price at which it can execute your order on the spot market. So the quoted price, in this case, is not an index. It is rather a representation of the combined liquidity of exchanges where the Broker fulfills your order. And it is in the Broker’s interest for the price to be representative of the market. Otherwise, nobody would use it.

Further on, leverage, by definition, means that positions you open are times larger than the amount of your own funds you use for those positions. Hence, leverage involves borrowing. What exactly you borrow is important.

On some platforms, your borrowed capital equals the difference between the position size and your own funds. On other platforms, your own funds represent a collateral, and your borrowed capital equals the entire size of the position.   

So, in two different cases the financing fee is applied to a different amount. Hence, the cost of trading is different. Not to mention that the financing fee itself can vary, as does the frequency with which the financing fee is applied.  So your leverage is more than the number before “x”, 3x, 10x, 100x. What instrument provides that leverage affects trading in multiple regards. So if you didn’t know, now you know! Moving on!

Liquidity 

Liquidity is something a lot of people like talking about, but not many people know exactly what it means and why liquidity matters. In the context of trading, liquidity represents the “depth” of the market.

And the depth means the volume of the working (currently active) limit orders on a platform within a narrow range around the market price. To put it simply, you can add 0.1% to and subtract 0.1% from the market price, and the value of all limit orders falling into this price range will represent your liquidity.  

A liquid orderbook means that even a big market order from a trader will be executed without a significant change from the price level at which it was placed.

Lack of liquidity means that a tiny bit sizable order will move the price. It is called “slippage” - when the price at which a market order was placed differs from the price at which the order was actually executed. A small slippage is fine and quite common. Significant slippage bites off a big piece of your potential profit. 

Because there are various types of margin trading platforms (see above) - they can solve the liquidity issue differently. For example, on the spot market (e.g. Kraken margin trading) and futures market (e.g.BitMEX) the liquidity is provided by the participants of the specific market. The limit orders they place are precisely what forms the liquidity there.

But a different setup is also possible. The liquidity can be supplied by other exchanges, liquidity providers, with whom the trading platform has agreements in place. For example, that’s the case with CEX.IO Broker. An order there is routed to one or a combination of liquidity providers for execution. 

Whether the liquidity is supplied by the market participants or by the liquidity providers, neither option is superior to the other. What’s important is to understand how liquidity works on a platform you are trading on. You don’t need an MBA from an Ivy League school for that - just need to know where to look. In the first case (liquidity is formed by the market participants) - the orderbook is your reflection of the liquidity situation. Significant order volume within a small range around the market price - great! Not too much - then expect slippages. 

In the second case (with liquidity providers) - sometimes the platforms are showing an oderbook formed by the consolidated liquidity from other exchanges. If so - then see the above. If not - only testing how your orders are executed on the platform will help you assess the liquidity.   

Note, however, that your own order size matters here. If you trade with the money you’ve saved up skipping the $13 salads for lunch - you got nothing to worry about. If you sold your car to go all in with 100x leverage (don’t do it!) - think twice! Big market orders can eat up the liquidity on a platform quickly and execute with big slippages. From slippages to wide spreads, typical to illiquid markets, liquidity on a trading platform is something that affects the cost of your trading and your resulting ROI. So instead of being enticed by the sexy features a platform offers, spend some time understanding the liquidity situation on it. Liquidity is the pulse of trading - check this pulse first so that you don’t end up playing on a dead market.

Latency

Latency is another aspect of trading, not apparent from the home page of a trading platform but affecting the quality of your experience of the market. Latency is a time interval (delay) between an instruction to send data and the delivery of that data. And now let’s put it simply: remember your conference calls with an office across the ocean? Your foreign colleague opens his mouth saying something and it takes time (forever) before you can hear him. That’s your latency.   Now, closer to trading. Imagine Bitcoin is nosediving, but when the price updates on your screen - it is already at a different level in the market. Then you want to open a position at a good price, but when the system actually sends your order to the market, the price is no longer relevant. As a result, you either opened a position at a bad price (if that was a market order), or didn't open a position at all (with a limit order). In another scenario, your position simply gets liquidated, and you did not even have a chance to do anything about it. You get the idea.   Latency happens because the little gnomes in computers can only spin the wheel with a limited speed. They spin the wheel to realize some logic - what data to send between the parts of the system, what price to show, how to execute an order, etc.

But sometimes the speed of the gnomes’ spinning is inadequate relative to changes on the market. Add the fact that you are trading with leverage - and even a split of a second is enough to make you feel like you are losing control. 

With latency on the overseas conference calls or with a latency on your trading platform - you can get used to everything. Yet, well-trained gnomes who can spin fast are always better. What it depends on is the infrastructure quality and the logic behind the order execution. Both can be done poorly and over-complicated even on the prettiest of trading platforms.  

The problem is, you, as a user, cannot come to a trading platform with “What’s up with your gnomes?” question. Some platforms tell users about their low or ultra low latency as their advantage.

But in practice, you can only verify that by using the platform. If trading reminds you of the dialup modem internet times - you got latency. In trading, especially in margin trading, this is unacceptable and impractical.   

Liquidation

One way or another a scary liquidation touches every trader. Liquidation means a forced closure of a trader’s position. Why does a platform close a position without asking the trader? To manage the risks of potentially uncontrollable losses. Since a trader’s position is opened with leverage (hence, some of the capital is borrowed), a certain pre-specified minimum level of funds needs to be maintained on it at all times in order to keep the position open. If a position suffers losses, making the funds available to guarantee the open positions insufficient, and if a trader does nothing to remedy the situation (e.g. adds more funds or closes the money-losing positions) - the platform has to initiate liquidation. 

Nobody likes to suck up the losses, especially if the price bounces right back after your liquidation, a sure way to start believing in conspiracy theories! Yet liquidation itself - is a form of a payment for using the margin trading facilities per se.

Many beginner traders think of liquidation as a bedtime scary story or a break time meme theme. Yet until they see zeros (or, better yet, minuses) on their trading account, they do not understand how liquidation works specifically on a platform they use. And that’s a process that can vary greatly from place to place. Respectable trading platforms provide detailed information about their liquidation process and warn a trader when the liquidation is nearing with margin calls. Others make liquidation akin to some sorcery that leaves you naked at the end.  So you better not fool yourself that liquidation will never touch you. No matter how lucky you are or how savvy you get, understanding what initiates the liquidation and how it unfolds will always put you well ahead of your fellow traders (and save you a ton of money and hidden tears in process).  

What initiates the liquidation is usually a metric in your trading account finances that crosses a certain threshold. For example, in CEX.IO Broker, this metric is Margin Level. The Marin Level needs to stay above a certain level, otherwise liquidation starts. For other platforms, indicators like liquidation price, maintenance margin will usually show you the right direction. Do not just learn which indicator you need to track, understand how it works, better than you understood your favorite subject at school!

How liquidation unfolds is a question of whether the liquidation is partial or full. Partial liquidation closes just enough positions to restore the indicator mentioned above to a defined level. So some of your positions may still survive. Full liquidation - simply liquidates all your positions. Ouch.

Another important thing:

The rollercoaster of price movements can lead to a situation when your deposit does not just liquidate to zero. You end up with a negative number on your account. Some platforms absorb the negative balances resulting from the liquidation (or guarantee that negative balances won’t happen). Others - don’t. You need to know this in advance. One thing is to cry over a liquidated deposit, another is to cry while having to hide from your creditors trying to collect your debt. And, of course, there is a cherry on top! Liquidation fee - ta-da! Oh yea, after all the sadistic pain you’ve been put through with the liquidation of your positions, some platforms (e.g. BitMEX) charge you a (sizable) liquidation fee. That fee goes to a fund which is supposed to guarantee that, after you are liquidated, you do not owe anything. Logically, the liquidation fee is charged at the moment of liquidation. Double ouch.   We can talk a lot about liquidation. Or you can search some liquidation memes for the inspo. But instead of letting the liquidation spectacularly undress you in the most opportune moment, you are much better off making an effort to understand how it works on the platform before you use it. 

The dream, the nightmare, and the messy middle 

Leverage, Liquidity, Latency, and Liquidation are the terms that you will definitely come across in your margin trading. They all affect both your trading experience and your experience of the market in multiple ways. How these things are implemented can make trading on two similar-looking platforms feel like two different worlds. So get to know them. Trading is something that can potentially put you on an adventurous quest, professionally and personally. And with any quest, there is a dream that makes a hero to venture on a new path. Then there is a challenge - a nightmare of sorts - that can stop the hero from getting what he wants. And there is also a messy middle - not so apparent plot twists that all turn out to be key for a journey.

Similarly, in trading, leverage may be that dream of making it big straight out of a fabulous exotic location. Liquidation - is that nightmare that will one day make you question your path. And liquidity and latency are both the things you may not notice at the beginning of your trip, but they will be there to trip you up midway. Know your dream, your nightmare, and your messy middle - and you are one good hero ready for your journey.