Margin trading involves trading assets by opening a long or short position on margin using borrowed funds provided by a third party. The benefits of margin trading include access to greater quantities of capital through utilization of a technique called leverage. Margin trading thereby can amplify trading results so that traders can realize greater gains.
Borrowed funds used for opening trading positions can either be borrowed from a broker dealer or financial institution as is typically the case in CeFi, or funds can be provided by other market participants or traders. Typically in the cryptocurrency markets, borrowed funds are provided by other traders or individuals seeking to earn a yield by lending out funds.
When a margin trade is opened traders will commit a percentage of total order value as collateral or also referred to as margin. Margin trading is utilized in order to obtain greater leverage. Margin trades can either be long positions or short positions. In case the trade moves against the trader, the margin or collateral will be liquidated in order to ensure the lender is able to reclaim their lent funds. This is referred to as a liquidation. Typically before a position is liquidated, there will be a margin call, whereby the trader is offered the opportunity to increase the collateral value in order to prevent the position from falling below a certain collateral ratio and become liquidated.
In much the same way that gains can be magnified with margin trading, so too can losses be greater because a trader can lose a larger amount of capital when in a leveraged position compared to a spot position.