Introduction to margin and leverage
Margin is the process of using borrowed funds from an exchange to trade an asset; leverage is the ability to amplify those funds for trading.
In this article, we introduce the basic concepts of margin and leverage. They are important to understand for trading futures and perpetual contracts.
Margin is the process of using borrowed funds from an exchange to trade an asset which forms the collateral for the loan from the exchange.
Leverage, provided by margin, is the ability to amplify both gains and losses. If it’s a loss, a margin call may have the exchange liquidate the user’s funds without prior consent.
To fully understand leverage, we first need to start with margin.
Margin is the amount of capital a trader has decided to put at risk for trading, it is the collateral used to offset the debt (leverage). Some exchanges differ in the way they handle margin for their traders.
- FTX uses “subaccounts” so traders can have an account for trading spot, and another for trading futures/perpetuals.
- Kraken has a margin wallet separated from the main user's wallet, so traders can trade spot from their main wallet, and trade on margin from their margin wallet.
These measures are for convenience and user protection.
For example, with subaccounts, exchanges provide traders a way to monitor which strategies are more effective. Additionally, having margin accounts separate from their main account allows users to expose limited capital and protect themselves from having their whole account liquidated.
Leverage by definition is the amount of borrowed capital a trader can decide to risk, it allows a trader to increase their portfolio exposure to a notional size larger than their current portfolio value, therefore enabling them to enhance their returns. We’ll look at some examples of going long or short to understand how margin and leverage work together in futures and perpetual contracts.
Suppose the trader is on FTX, with a Main Account and a “Subaccount1”.
10x Long example
The trader has $1,000 in their Subaccount1 wallet and wants to go 10x Leverage Long on Bitcoin. To find out how much they need to buy, we multiply their margin with leverage.
Margin x Leverage = Notional size
$1,000 x 10 = $10,000
The trader buys $10,000 worth of Bitcoin Perpetual Futures contracts (BTC-PERP). That value, the total size of their position, is referred to as the notional position size. So the formula is margin x leverage = notional (position) size.
Let’s look at another example.
3x Long example
The trader has $500 in their Subaccount1 wallet and wants to go 3x Leverage Long on Bitcoin. To find out how much they need to buy, we multiply their margin with leverage.
Magin x Leverage = Notional size $500 x 3 = $1,500
The trader buys $1,500 worth of BTC-PERP.
These examples work regardless of whether the trader is Long or Short.
10x Short example
The trader has $200 in their Subaccount1 wallet and wants to go 10x (Short) on Bitcoin.
$200 x 10 = $2,000
The trader sells $2,000 worth of BTC-PERP. That’s their position size, a -$,2000 worth of short exposure to Bitcoin.
The relationship between margin x leverage = notional size holds in all future and perpetual contracts.
Note that margin is specific to the instrument being traded. For example, a trader is trading the Ethereum perpetual contract, ETH-PERP. Only the ETH balance and margin is relevant and at risk for that type of trade. The trader’s BTC balance and margin is not at risk (of course, assuming there are no BTC positions open).
- Margin is the collateral a trader has designated as available for trading, and it’s specific to the asset being traded.
- The notional position size is the trader’s total position size, which can be Long or Short.
- And finally, margin x leverage = notional size.
Changes in prices
In this section, we describe how margin and leverage respond to changes in price.
When using leverage, traders make profits or losses based on the notional amount.
- Profits on the notional size are added to the trader’s margin account/balance;
- Losses on the positional size are subtracted from the trader’s margin account/balance.
For FTX, it would be the trader’s “Subaccount1”, for Kraken, it would be the trader’s “Margin Balance”. It depends on how exchanges handle their customers' accounts.
Remember that the point of separate subaccounts is for traders to have a safeguard against liquidation: if something goes wrong, only that specific subaccount is at risk, not the trader's main account on the exchange.
How does price affect margin & leverage
A rough heuristic to use is to take the percent change in price and multiply it by the leverage to find the percent gain or loss on the margin balance.
For example, if a trader is 3x Long and the price goes up by 10%, they’ll have a +30% gain on their initial margin.
Leverage x price change = initial margin 3 x 10 = +30%
Another example: if a trader is 5x Short and the price goes up by 10%, they’ll have a -50% loss on their initial margin.
Leverage x price change = initial margin 5 x 10 = -50%
The fact that there’s 10% change in price can lead to a much larger change in the trader’s margin balance is the reason why it’s commonly said that “Trading with leverage magnifies gains and losses”.
Note that as a trader makes a profit on a trade, their margin balance goes up. If the margin balance goes up, the notional position size remains constant, and the trader’s leverage level reduces.
So as the trader makes a profit, their leverage goes down.
Conversely, if a trader makes a loss on a trade, their margin balance goes down. If the margin balance goes down, the notional position remains constant, and the trader’s leverage level increases.
So as the trader incurs a loss, their leverage goes up.
Margin and leverage provides users the ability to generate higher returns than what they could achieve with their personal balance.
But using leverage may also lead to significant losses. If the value of the asset declines, users may be left owing more money than their initial collateral amount and carry the risk of being liquidated.