Imagine you could trade with up to 2x, 10x or even 100x your crypto holdings, without having to actually hold the capital required in order to open such positions? Well, with margin trading, you can.
Well, let us introduce you to the wonders of crypto margin trading. Here we will explain the intricacies of margin trading in beginners terms. Just as we demonstrate the incredible profits you can make, we’ll also warn you of the risks. If you thought HODLing crypto was for the thick-skinned, leveraging is a whole other ball game that requires alligator epidermis. But, presuming you take the time to educate yourself and practice with small margins, and you do end up making some profits, we’ll let you know how these are taxed.
What is crypto margin trading?
To put it short, margin trading is as simple as this: you are trading with borrowed funds so you maximise your return on investment. Once your position is finished, you pay back the borrowed funds to the third party (with small interest), but keep the extra profits. If done successfully, you will walk away with more profits that you would have if you just used your own funds.
As mentioned, the borrowed funds are provided by a third party. In the case of crypto, it will be the exchange you are trading on, or other unknown crypto traders on the platform (but where it's from doesn’t really matter much).
In order to borrow funds, you need to have collateral (an asset a lender accepts as security for a loan — if the borrower defaults on their loan payments, the lender can seize the collateral and sell it to recoup some or all of its losses) that the exchange will hold in place.
By putting these funds into an exchange, you put a percentage of them up as collateral. This is what allows you to borrow more than you actually have.
By borrowing more than you actually have, you can use something called leverage. This multiplies your trading amount by up to 100 times more. This increases the interest percentage you earn from trades. Why? Let's say you get a 10% interest on a trade, and you have $100. At the end of the trade, you will get $110, earning $10 in interest and profits. However, if a third party gave you an extra $600 to trade (meaning you have $700), that 10% interest is going to earn you $70.
At the end of the process, you pay back the borrowed funds with a small fee (usually minimal), but keep the larger interest. This means that the interest you earn on the trade will be much higher than if you just used owned funds.
However, keep in mind that there's risk involved here. Although the returns are much greater (higher leverage = higher returns), the risk is also much higher (higher leverage = higher risk).
What is an example of crypto margin trading?
Let’s say you have $100 of owned funds. You want to do some higher risk margin trading with a leverage of 10x.
In this example, the price of Bitcoin is $10,000. We’re going to use a leverage of x10, so the margin is $1,000.
When the price of BTC increases by +5%, your margin profits increase by +50% ($500).This is because the price change is 5% on the market, but because we are using 10x leverage, it goes to 50%.
As the price continues to move up, so does our leverage: +10% = 100% ($1,000), 15%= 150% ($1,500) and so on. Sounds great right?
Well, you have to keep in mind that the reverse of this scenario is also possible. If the price falls by -5%, you lose -50% of your margin (-$500). If the price continues to fall towards the initial margin (which in this case was $1,000), you run the risk of being liquidated.
Now, being liquidated does not mean you are shot with some alien ray gun and turned into liquid goo on the floor. No. Liquidation is what happens when the market moves against your trade, so far that your loss is the same amount as your margin. The exchange converts your funds back and closes your position. This is what makes trading with leverage so risky. Much more risky than spot trading, for example.
What is shorting in crypto?
Another interesting thing margin trading can do is shorting - you might remember Margot Robbie explaining this in The Big Short or heard about the GameStop shorting scandal. Shorting is essentially where you sell at a high price and buy back what you sold at a lower price. This distance in price becomes a profit. Let’s see an example.
Your entry price is $10,000 for 1 BTC. You’re using 10x leverage, so your margin is $1,000. You are shorting the Bitcoin, which means you are betting on it to go down. If the price decreases by -5%, you make +50% of your margin ($500). If it moves down -10%, you make +100% of your margin ($1,000).
However, if the trade moves against you and goes up in price, you will start losing profit. If the price goes up +5%, you lose -50% of your margin. Similar to before, if your price moves up too far and your margin equals your loss, then you are forced to liquidate.
What are the best crypto margin trading exchanges?
The first exchange that comes to mind with this is Binance. It is currently the world’s biggest crypto exchange by volume and has one of the most diverse ranges of crypto assets. In terms of margin trading, the exchange provides you with leverage of up to x3 and one of the highest liquidity in the market.
During margin trading, Binance has its own meter to measure the risk of your trades. It represents the amount of risk you’ve taken by borrowing the funds. The meter changes according to the market, and if your prediction goes sideways, Binance will liquidate your funds.
With Kraken, margin trading is accessible to everyone. They have a decent 5x leverage limit. Another benefit of margin trading on Kraken is that their fees are low. Depending on the currency pair you’re trading in, they charge only 0.02% to open a position.
ByBit is an exchange that offers crypto spot and margin trading. Incredibly, it has a leverage limit of up to 200x on BTC. This means you could get up to 200 BTC by having a capital of 1 BTC. This is very cool, but keep in mind the risks with such trades are off the scale.
How is crypto margin trading taxed?
Right, here we are. There’s quite a few elements and actions to margin trading, so let's go through them one by one.
- Collateral: When you deposit collateral for a crypto loan, this is not considered a taxable event.
- Gains: Margin traders are responsible for any capital gains they earn with borrowed funds. To see the US rules on capital gains, refer to this guide.
- Losses: When you lose profits in margin trading, this can offset net capital profits. In the US, you need to keep track of these and report them on Form 8949 when it comes to tax season.
- Liquidation: losing assets through forced liquidation, or not fulfilling a margin call, is considered a taxable event or disposition. Capital Gains Tax applies.
- Fees: transaction fees you paid for during margin trading, such as interest, can be added to your asset’s cost basis.
Now, to make things easier, let’s look at an example of how crypto margin trading is taxed.
You own $1,000. You borrow 10x your amount to create a leverage. You now have $10,000 to trade.
You use this to buy 5 ETH at $2,000. After a while, ETH goes in value to $3,000, and you sell your 5 ETH for $15,000. You return the borrowed $10,000 back to the exchange, leaving you $5,000 in profit. You will owe Capital Gains Tax on this.
However, you also paid $850 in interest and fees. This can be deducted from your taxable gains amount, meaning you will be liable to pay taxes on $4,150 of gains.
How crypto tax software can help
Koinly is a crypto tax tool that calculates your crypto taxes for you, meaning you don’t have to go through the hassle of doing it yourself.
Not only does the software integrate with your exchanges' transaction history, but it calculates your taxes in a format that makes sense for your country’s tax authority. Essentially, Koinly does all the boring tasks that would cost your hours and hours sitting at a computer.
As a quick breakdown, here’s a short summary of what Koinly does:
- Imports all your trades including purchases, sales, swaps, and rewards.
- Converts your transactions into your country’s currency at fair market value (this in itself is a massive time saver).
- Deciphers which of your transactions are taxable and which are not (you may sometimes need to do some fiddling, but for the most part the software organizes it for you).
- Allows you to submit a clean and accurate report to your tax office.