We recently covered the growth in the area of crypto derivatives
. As crypto gains legitimacy as an asset class derivatives grow into a larger proportion of the overall markets, in line with traditional markets.
Margin trading in a nutshell:
While the potential rewards can be high, there are some sizeable risks that investors need to contend with too.
Let’s start with an example using dollars. Imagine you have $50. Margin trading is where you could gain exposure to, say, $500 using a 10x leverage, based on this $50 in your pocket.
As you can imagine, the principle in the cryptocurrency world is quite similar. Let’s say you want to buy Ethereum worth $1,000, but you’ve only got $500 available. Through margin trading, you’d be able to borrow an extra $500 – getting you up to the magic total.
If your $1,000 in Ethereum grew in value, to say $1,500, you’d be able to liquidate it and return the $500 to the lender, leaving you with a gross profit of $500. In the unlevered scenario you would have only made a $250 gain on your $500 investment. For the moment, let us ignore borrowing costs.
Of course, the value of cryptocurrencies can go dramatically down as well as up. In a scenario where the price of Ethereum went down by 50 percent, your lender would be able to get their $500 first before you can access funds, potentially leaving you with nothing.
In the traditional finance world, margin trading is predominantly employed by sophisticated hedge funds, typically with leverages varying from 1.5x to sometimes even more than 5x, depending on the asset class and strategy, which use a variety of complex strategies to achieve superior returns. On the flip side, excessive leverage can completely wipe out invested capital, as was the case with Long Term Capital Management (LTCM), one of the largest hedge funds of its time that eventually collapsed. In case you have not, you should definitely check the seminal When Genius Failed
, which chronicles in detail the circumstances around the collapse of LTCM.
Margin Trading in the context of cryptocurrencies:
As we opined in our last week’s piece,
a majority of derivatives trading in cryptocurrencies happens on unregulated exchanges. One of the unique features of crypto trading is the excessive leverage (up to 200x) that is offered to woo unsophisticated retail investors with the indirect promise of earning very high returns on investment in a short period of time. Leverage is often cited as the cause of financial bubbles and 100x leverage in a highly volatile crypto space raises the stakes to a new level. With 100x leverage, a 1% move in the right direction can net you 100% return before fees and funding costs in just a matter of minutes. On the flip side, if the price moves by a few ticks in the wrong direction, your entire capital will be wiped out. What makes matters even worse is the lack of regulation and the presence of whales
who are often accused of market manipulation.
BitMEX recently released some insightful statistics on the high stakes leverage game that most traders on BitMEX engage in.
The dichotomous nature of the distribution shows that while a majority of traders’ use leverage in a more reasonable and measured manner, there still exists a significant chunk of traders who are drawn towards the 100x leverage offered by leading crypto exchanges.