Spot vs Margin: What’s The Difference?
The popularity of buying and selling assets has increased in recent times, and it is expected to continue growing. There are different types of assets and financial instruments, as well as different methods and processes to trade them. Although it is possible to combine both spot and margin trading, the suggestion is to focus on one of these markets, especially if you are new to trading financial resources. Investors will choose the trading form that suits their needs and is based on their goals. It is, therefore, necessary to learn about the different trading processes before exchanging any type of asset, that is, to understand each method’s advantages and disadvantages and why they differ from each other to avoid losses.
What is Spot Trading?
Spot trading is considered one of the most basic methods for buying or selling financial assets for immediate delivery, and the most common form of trading. It is a quick, easy way to trade forex, stocks, bonds, shares, commodities, or even digital currencies, like Bitcoin (BTC), Ethereum, DOGE, or other altcoins. Investors can purchase assets on the spot at the current market rate – also known as “spot price” – looking forward to selling them at a higher price over time to profit.
Since this deal type is immediate, investors must have the available assets to pay for their trades by the day of settlement. Actually, this is one of the reasons why a spot transaction is likely the first experience within the financial world for those getting started with crypto investing, for instance. Another reason is that different currency exchanges run online. Thus, spot trades can occur any day, at any time, and anywhere in the world. In the case of crypto trading, spot exchanges such as Binance, Coinbase, or Kraken encompass order books, buyers, and sellers who agree on bid-offer prices after posting their orders to facilitate the trading process.
Regarding fees, in spot trading, investors pay the exchange from 0.1% to 2% trading fee, which is deducted from the currency they receive. Additionally, the account fee level is determined not only by the exchange used, but also by the trading pairs and the trading volume.
Spot trading is a fairly straightforward procedure, and there are some easy steps to bear in mind. First, understand what spot trading is before selecting a market to trade. Second, sign up for an exchange and verify your account. Third, add funds to the trading account you will use for trading. Finally, go to the exchange spot market and start trading.
Types of Spot Markets
Over-the-counter (OTC) and market exchanges are the two types of spot markets. In the OTC market, investors meet to trade on a bilateral basis through consensus. To put it another way, the exchange of assets is not regulated by a central third party. Moreover, terms such as quantity and price, among others, may not standardize assets traded on the spot, different from the norm on organized exchanges. Hence, the two parties involved negotiate all terms of trade and complete the transaction on the spot.
Meanwhile, in an organized market exchange, investors meet to trade assets on an electronic trading platform or a trading floor. As there are numerous trades in some exchanges on electronic platforms to buy and sell assets, prices here are determined right away and coordinated through many traders’ offers. Thus, spot prices can change every second or even milliseconds.
A significant difference between these two types of spot markets is that market exchanges regulate operations and standardize all procedures and trading. The New York Stock Exchange (NYSE) and the Chicago Mercantile Exchange Group are good examples that should be mentioned.
Advantages and Disadvantages of Spot Trading
Each trading form has arguments in favor and against them, which should be considered before starting any financial transaction. As stated previously, buying and selling assets on the spot is a straightforward process. Thus, it can be easier to understand its rules, risks, and rewards, which is a benefit.
One upside of this trading form is that new traders do not need to worry about being liquidated or getting a margin call. The reason is quite simple: they can invest in the market and exit a trade according to their desire. There is also no need to keep checking their investments, except when investors want to make short-term transactions.
Another upside of trading on the spot is obvious: right after you complete your asset purchase, it is yours to own. Moreover, with this form of trading, it is easier to manage risk because investors only rely on the assets they own. In this way, they cannot lose more than the invested amount, but they can multiply their gains. For example, if you buy $5,000 worth of BTC, it is only possible to lose $5,000, but the profits you can make over time are, in theory, limitless.
However, managing risk can also be a downside in some situations due to the potential profits, which will be limited. For instance, if you have $35,000 in your account, you can only make as much as that amount allows you to make. In other words, potential profits will be bound to the capital you own. Additionally, spot trading moves with the market. So, the account would drop if there is a drop in the market, just as uptrends would increase it. Hence, it is crucial to understand buying and selling digital currency on the spot can be very volatile.
What is Margin Trading?
Margin trading refers to a process in which investors borrow money from a brokerage to trade an asset. In other words, by trading on margin, investors are allowed to buy more financial assets than what they can afford, as they only pay a fraction of the total price of the asset. In this context, traders can win or lose higher amounts of initial investment through leverage, which allows them to trade on equity their positions.
Those who trade on margin can make further financial gains on thriving trades, as this method multiplies trading results. Due to this feature, margin trading has become well-known in markets that stay relatively stable, usually referred to as low volatile, as well as in stock and commodity markets and exchanges of the digital world.
As opposed to trading on the spot, buyers or sellers on margin do not need to own the available equity to buy their assets by the day of settlement. Instead, they can deposit funds to a margin wallet to be held as collateral. However, they have to realize they must return the money borrowed. Depositing $1,000 to your margin account allows you to open a $1,000 BTC/JPY position without owning any JPY or BTC, for instance. When trading digital currencies, other dealers provide the assets, aiming to charge interest for the portion of the margin used for the holding period, just like a bank loan. Thus, borrowing funds allows margin traders to access more significant profits.
After initiating a margin trade, the requirement for the investor is to execute initial funding. The margin, i. e. the fee charged from the total order, is directly associated with the leverage. This concept describes the ratio of borrowed funds to the margin. For instance, to open a position at $10,000 with a leverage of 10:1, it would be necessary to commit $1,000 of the capital. It is important to remember that leverage ratios vary according to the type of investment, such as stocks, Forex, or crypto, and between trading platforms. In the crypto market, leverage ratios are written as 2x, 5x, 10x, 50x, 100x.
It is also crucial to be aware of the maintenance margin for any positions you take. A 25% maintenance margin on a $100,000 stock position using 4:1 margin means there must be at least $25,000 in capital to maintain the position. For this reason, to use all the margins in an account at any given time is not recommended. Instead, it is imperative to leave a buffer because the more you leverage, the smaller the move in the underlying stock before a margin call can trigger.
Long and Short Positions
When talking about buying or selling stocks, there are two types of positions that you can take: long and short. This terminology makes a reference to whether the investor believes the stock price will increase or decrease.
On the one hand, you can initiate a long position trade once you assume that the price of any given asset will increase. Essentially, the trader buys it expecting to sell it at a higher price to make a profit later. For growth investors, the expected increase in the asset’s price is attributable to a predicted increase in the asset’s future value. However, for value investors, it is attributable to the inherently inefficient market, realizing the true current value of the asset.
On the other hand, you can initiate a short position trade by borrowing an asset to sell it, aiming to repurchase it at a lower price, take a profit, and then pay back the dealer who loaned them. This investment strategy is less common. Investors trading with a short position bank on a decrease in the asset’s price, in contrast to a long trade, which represents the main difference between these two types of positions. Some growth investors will go short when they expect the rate of future growth to decline. Meanwhile, value investors are most likely to take a short position when they feel that an asset is overpriced in relation to its underlying value.
Advantages and Disadvantages of Margin Trading
Margin trading has both good and bad sides in the stock market or every other market. So, before embarking on this buying and selling strategy, it is crucial to have a knowledge of how everything works to prevent costly mistakes.
One of the main benefits for margin traders is that they may get higher gains due to the higher relative value of their trading positions. It is possible to increase purchasing power and allow margin investors to amply profits if they increase the capital available to buy assets. Apart from that, as you can open more than one position in multiple currencies without much investment capital, this trading form helps to diversify your portfolio. Spreading investments around is possible as long as you use the margin buying power if you hold a concentrated stock position in your margin account. Hence, this trading form will also help you to spread out your risk across multiple tokens.
While margin trading has its benefits, as a consequence of leverage, it also has disadvantages. A major downside is that buying and selling assets on margin increases losses as well as it can increase gains. Margin traders assume responsibility for returning the borrowed funds, so the possibility of losses could exceed their original outlay. Therefore, bullying and selling assets on margin is a high-risk trading form. Even if the market price drops insignificantly during the transaction, there is room for substantial losses for investors.
Another disadvantage, if you choose margin trading, is the liquidation risk. With this type of trading, if a trader’s position moves against them, and they do not have enough collateral to cover the losses, there is room for them to be liquidated. The exchange, in other terms, will close a trader’s position and recoup the initial margin to keep itself from any further losses on what they borrowed.
Considering all these ups and downsides, it is crucial to make use of risk management strategies, like determining the risk per trade, filtering trades using the risk/reward ratio, and determining the position size. Additionally, you can employ risk mitigation tools, such as stop-loss orders.
With more people and institutions starting to make investments, it is inevitable to spark your interest in this financial world. Whether you are a beginner or already have some or even plenty of experience with online currency exchanges, you should know that spot or margin trading is one of the biggest dilemmas of every trader. That is no wonder, as the trading form used can lead them to higher profits or losses.
Trading any type of assets and financial instruments is not something you should enter into lightly. Before embarking on it, ensure that you understand how trading on the spot and margin work and set your goals and needs. Only then will you be able to make successful trades. The spot market is a base for all other types of trading, as it reflects accurate quotations. Thus, spot trading might be the best option for you if you are starting trading or looking for immediate delivery, and have the available assets to pay for your trades. However, if you have already accumulated expertise in spot trading and want a tool to make impressive gains – at the same time accounting for its risk of excessive loss – you may start trading on margin.