Summary
Isolated margin and cross margin are two different types of margins available on many cryptocurrency trading platforms.
In isolated margin, investors decide how much funds to allocate as collateral for a specific position, and the rest of the account balances are not affected by this trade.
Cross margin uses all available funds in your account as collateral for all trades. If you have a losing position, but have another that is winning, the profit can be used to cover the loss, allowing you to keep your position open longer.
The choice between isolated margin and cross margin depends on an individual's trading strategy, risk tolerance, and how much they want to actively manage their positions.
What is margin trading?
Before delving into isolated margin and cross margin, let's briefly look at what margin trading is. In margin trading, investors borrow funds from an exchange or broker to buy or sell more assets than they could afford on their own. They use assets they have in their accounts as collateral to go into debt and make larger trades, hoping to make bigger profits.
Let's say you have $5,000 and you think the price of Bitcoin will increase. You could buy $5,000 of Bitcoin directly or leverage your position to trade with borrowed funds. Suppose the price of Bitcoin increases by 20%. If you had invested your $5,000 without leverage, your investment would now be worth $6,000: the initial $5,000 + $1,000 profit. That represents a 20% profit on your initial investment.
However, if you had used 5:1 leverage on your $5,000, you would have borrowed four times the amount you have, and you would have $25,000 to invest: $5,000 of your original capital and $20,000 as a loan. With a 20% increase in the price of Bitcoin, your $25,000 investment would now be worth $30,000: the initial $25,000 + $5,000 profit. After paying off the $20,000 loan, you would have $10,000 left. This represents a 100% return on your initial investment of $5,000.
Remember that margin trading is a highly risky activity. Let us now analyze the opposite situation where the price of Bitcoin falls by 20%. With a 20% drop, your $5,000 investment without leverage would be worth $4,000: the initial $5,000 minus $1,000 loss. But with 5:1 leverage, your $25,000 investment would be worth $20,000: the initial $25,000 minus $5,000 loss. After paying off the $20,000 loan, you would have nothing left and you would have lost 100% of your initial investment.
This simplified example does not include trading fees or interest that may be due on borrowed funds, which would reduce your profits in real trading situations. It is important to remember that the market can move very quickly and cause losses that could even exceed your initial investment.
What is the isolated margin?
Isolated margin and cross margin are two different types of margin available on many cryptocurrency trading platforms. Each mode has its own usefulness and risks. Let's try to understand what they are and how they work.
In isolated margin mode, the amount of margin is limited to a specific position. This means that you decide how much of your funds you want to allocate as collateral for a specific position, and the rest of your funds are not affected by that particular trade.
Let's say you have a total balance of 10 BTC in your account. You decide to open a leveraged long position in ether (ETH) and assume that the price of ETH will rise. You allocate 2 BTC as isolated margin for this particular trade with 5:1 leverage. This means you are trading 10 BTC worth of ether (2 BTC of your money + the 8 BTC leveraged position).
If the price of ether rises and you decide to close the position, any profit you make is added to your original 2 BTC margin from this trade. But if the price of ether drops sharply, the most you can lose is your 2 BTC isolated margin. Even if your position is liquidated, the other 8 BTC in your account will remain intact. Hence its name "isolated" margin.
What is cross margin?
Cross margin uses all available funds in your account as collateral for your trades. If you have a losing position, but have another that is winning, the profit can be used to cover the loss, allowing you to keep your position open longer.
Let's see how this works in an example. You have a total balance of 10 BTC in your account. You decide to open a long leveraged position in ether (ETH) and another short leveraged position in a cryptocurrency we will call Z, using the cross margin mode. For ether, you trade 4 BTC worth with 2:1 leverage; and for Z, you trade 6 BTC worth, also with 2:1 leverage. Your entire 10 BTC account balance is used as collateral on both positions.
Suppose the price of ether falls and causes a potential loss, and at the same time the price of Z also falls and creates a profit for your short position. The profit from the Z trade can be used to cover the loss from the ether trade. In this way both positions remain open.
However, if the price of ether falls and the price of Z rises, both positions could be at a loss. If these losses exceed your total account balance, both positions could be liquidated and you could lose your entire 10 BTC account balance. This is very different from isolated margin, where only the 2 BTC you allocated to the trade would be at risk of loss.
Remember that these are very simplified examples and do not take into account trading commissions and other costs. Furthermore, real trading situations are generally much more complex.
Key Differences Between Isolated Margin and Cross Margin
From the mentioned examples, we can clearly see the similarities and differences between isolated margin trading and cross margin trading. We can summarize their key differences as follows:
Guarantee and settlement mechanisms
In isolated margin, only a specific portion of your funds on a particular trade is reserved and at risk. This means that if you trade 2 BTC in isolated margin mode, only those 2 BTC will be at risk of liquidation.
However, in cross margin, all the funds in your account act as collateral for your trades. If a position starts to lose, the system can use your entire account balance to prevent the position from being liquidated. And if something goes wrong in several trades, you risk losing your entire balance.
Risk management
Isolated margin allows for more granular risk management. You can allocate specific amounts that you are willing to risk on individual trades without affecting the rest of your account. Cross margin, on the other hand, combines risk across all your open positions. It can be beneficial when you manage multiple positions that can offset each other, but combined risk also comes with potentially larger losses.
Flexibility
In isolated margin trading, you have to add more funds to the position manually if you want to increase the margin. On the other hand, cross margin automatically uses the available balance in your account to avoid the liquidation of any position, which makes it less interventionist in terms of margin maintenance.
Use cases
Isolated margin is suitable for traders who want to manage risk per trade, especially when they have high conviction on specific trades and want to keep risks separate. Cross margin is best suited for traders executing multiple positions that can hedge each other, or for those who want to leverage their entire account balance and have a less hands-off approach to margin maintenance.
Advantages and disadvantages of isolated margin
Let's see one by one:
Advantages of isolated margin
Controlled risk: You decide how much of your funds you want to allocate and risk in a given position. Only this amount is at risk and you keep the rest of your funds safe from possible losses on that particular trade.
Clearer Profit and Loss (PnL): It is easier to calculate the profit and loss of an individual position when you know the exact amount of funds tied to it.
Predictability: By segregating funds, traders can predict the maximum loss they may suffer in the worst-case scenario, helping to better manage risk.
Disadvantages of isolated margin:
Requires close monitoring: As only a specific portion of funds are backing a position, you may need to monitor the trade more closely to avoid liquidation.
Limited Leverage: If a trade starts moving against you and is approaching liquidation, you cannot automatically draw on the rest of the funds in your account to prevent it. You would have to add more funds to the isolated margin manually.
Administrative management fees: Managing multiple isolated margins for different trades can be complex, especially for beginners or those managing multiple positions.
In summary, while isolated margin provides a controlled environment for risk management in leveraged trading, it demands more active management and can sometimes, if not used wisely, limit profit potential.
Advantages and disadvantages of isolated margin
These are the advantages and disadvantages of cross margin:
Advantages of Cross Margin
Flexibility in margin allocation: Cross margin automatically uses any available account balance to prevent liquidation of any open positions, providing more fluidity compared to isolated margin.
Offsetting Positions: Profits from one position can help offset losses from another position, making it useful for hedging strategies.
Reduced liquidation risk: By pooling your entire balance, the risk of premature liquidation on any position is reduced because a larger pool of funds can cover margin requirements.
Easier management for multiple trades: Simplifies the process of managing multiple trades simultaneously, since you do not have to adjust the margin of each trade individually.
Disadvantages of cross margin
Increased risk of total liquidation: If all positions move unfavorably and the combined losses exceed the total account balance, there is a risk of losing the entire account balance.
Less control over individual trades: As margin is shared between all trades, it becomes more difficult to assign a specific risk-reward ratio to individual trades.
Possible overleverage: With the ease of leveraging the entire balance sheet, traders may be tempted to open larger positions than they would with isolated margin, which can lead to greater losses.
Less clarity on risk exposure: It is more difficult to gauge total risk exposure at a glance, especially if there are multiple open positions with varying degrees of profits and losses.
An example that uses both the isolated margin and the cross margin
Integrating both isolated margin and cross margin strategies can be a nuanced way to maximize returns and minimize risks in cryptocurrency trading. Let's see it in an example.
Let's say that with the upcoming Ethereum (ETH) updates, you have a bullish outlook on that cryptocurrency, but you also want to hedge potential risks from overall market volatility. You think that although ether may rise, bitcoin (BTC) could fall.
You may consider allocating a specific portion of your portfolio, say 30%, to open a leveraged long position in ether using isolated margin. In this way, you will be covering possible losses at that 30% in case the ether does not perform as you expect. However, if ether appreciates in your perspective, you can make a significant profit on this portion of your portfolio.
With the remaining 70% of the portfolio, you use cross margin to open a short position in Bitcoin and a long position in another altcoin, Z, that you believe will perform well regardless of Bitcoin's movements.
By doing so, you use potential profits from one position to offset potential losses from another. If Bitcoin falls (as you predicted), your gains could offset any Z losses and vice versa.
After establishing these positions, you should continue to monitor both strategies. If ether starts a downtrend, consider reducing the isolated margin position to limit losses. Similarly, if Z, in the cross-margin strategy, begins to significantly underperform, you might consider adjusting positions.
By integrating isolated and cross margin, you are proactively trying to profit from your market predictions while hedging the risks. But while combining these strategies can help with risk management, it does not guarantee profits or protection against losses.
Conclusions
Margin trading, with its potential to increase profits, also carries an equal, if not greater, degree of risk. The choice between isolated margin and cross margin depends on an individual's trading strategy, risk tolerance, and how much they want to actively manage their positions.
In cryptocurrency trading, where volatility often predominates, it is essential to understand the complexities of both types of margins. A well-informed decision, coupled with diligent risk management practices, can help traders navigate the turbulent waters of the crypto market. As always, it is essential to conduct thorough research and, if possible, consult with experts before engaging in margin trading activity.
Further reading
What is margin trading?
What is leverage in cryptocurrency trading?
How hedging works in the crypto space and seven hedging strategies you should know
Legal Notice and Risk Warning: This content is presented "as is" for general information and educational purposes only, without representation or warranty of any kind. It should not be construed as financial, legal or other professional advice nor is it intended to recommend the purchase of any specific product or service. You should seek individual advice from suitable professional advisors. As this article is contributed by third parties, please note that the opinions expressed are those of the third party contributor and do not necessarily reflect those of Binance Academy. For more information, read our full legal notice here. Digital asset prices can be volatile. The value of an investment can go down as well as up, and you may not get back the amount invested. Only you are responsible for your investment decisions. Binance Academy is not responsible for any losses you may incur. This material should not be construed as financial, legal or other professional advice. For more information, please see our Terms of Use and Risk Warning.
