In margin trading, investors typically borrow funds from an exchange or broker to buy or sell more assets than they could purchase with their own capital. They use the assets they already have as collateral to take on this debt, aiming for bigger profits.
Imagine you have $1,000 and believe that the price of a cryptocurrency will rise. You have two options: you can directly buy $1,000 worth of the cryptocurrency, or you can leverage your position by borrowing funds. Let's assume the cryptocurrency price increases by 10%.
If you had invested your initial $1,000 without leverage, it would now be worth $1,100, resulting in a 10% gain.
However, with 3:1 leverage, you borrow twice your initial capital, giving you $3,000 to invest ($1,000 from your capital and $2,000 as a loan). With a 10% increase in the cryptocurrency price, your $3,000 investment is now worth $3,300. After repaying the $2,000 loan, you're left with $1,300. This represents a 30% return on your initial $1,000 investment.
It's crucial to keep in mind that margin trading involves substantial risk. For example, if the cryptocurrency price falls by 10%, your $1,000 investment without leverage would be worth $900, resulting in a 10% loss. However, with 3:1 leverage, your $3,000 investment would drop to $2,700. After repaying the $2,000 loan, you'd be left with $700, which is a 30% loss of your initial $1,000 investment.
This simplified illustration does not account for trading fees or interest on borrowed funds, both of which can impact your actual profits. Furthermore, the market can be highly volatile, leading to potential losses that may even surpass your initial investment.