TL;DR
Isolated margin and cross margin are two different types of margin available on many cryptocurrency trading platforms.
In isolated margin, investors decide the amount of resources they wish 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 one position moves against your strategy but another position makes a profit, 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 comes down to one's trading strategy, including risk tolerance and how actively the investor wants to manage their positions.
What is margin trading?
Before we cover isolated margin and cross margin, let's briefly explain what margin trading is. In margin trading, investors request loans from a broker to buy or sell more assets than they could allocate on their own. They use your account assets as collateral to take on debt and place larger bets in the hope of making a larger profit.
Let's say you have $5,000 and you believe the price of Bitcoin will rise. You can buy Bitcoin directly for $5,000 or leverage your position to make trades using 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 ($5,000 initial + $1,000 profit). This represents a 20% gain 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 own and would have $25,000 to invest ($5,000 of your initial capital and $20,000 of the loan). With a 20% increase in the price of Bitcoin, your $25,000 investment would now be worth $30,000 ($25,000 initial + $5,000 profit). After paying off the $20,000 loan, you are left with $10,000. This represents a 100% return on your initial $5,000 investment.
Remember, margin trading carries great risks. Let's consider the opposite scenario, where the price of Bitcoin drops by 20%. Your $5,000 investment without leverage would be worth $4,000 ($5,000 initial - $1,000 loss), suffering a 20% loss. However, with 5:1 leverage, your $25,000 investment would be worth $20,000 ($25,000 initial - $5,000 loss). After paying off the $20,000 loan, you would be left with nothing, losing 100% of your initial investment.
This simplified example does not include trading fees or interest that may be charged on borrowed funds, which would reduce your profits in real trading scenarios. It is important to remember that the market can move quickly, leading to potential losses that may even exceed your initial investment.
What is isolated margin?
Isolated margin and cross margin are two different types of margin available on many cryptocurrency trading platforms. Each type has its own associated benefits and risks. Let's understand what they are and how they work.
In isolated margin mode, the margin value 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 will not be affected by that trade.
Let's say you have a total balance of 10 BTC. You decide to open a leveraged long ether (ETH) position, betting that the price of ETH will rise. You allocate 2 BTC as isolated margin for this specific trade, with a leverage of 5:1. This means you are effectively trading ETH with a value of 10 BTC (2 BTC from your balance + 8 BTC from the leveraged position).
If the price of ETH rises and you close the position, any profit made will be added to your original 2 BTC margin for this trade. But if the price of ETH drops drastically, the most you can lose is your isolated margin value of 2 BTC. Even if your position is liquidated, the other 8 BTC in your account will remain intact. Hence the name “isolated” margin.
What is cross margin?
Cross margin uses all available funds in your account as collateral for your trades. If one position moves against your strategy but another position makes a profit, the profit can be used to cover the loss, allowing you to keep your position open longer.
Let's see how this works on an example. Suppose you have a total balance of 10 BTC in your account. You decide to open a leveraged long position on ether (ETH) and another leveraged short position on a cryptocurrency we will call Z, using cross margin. In the case of ETH, you are effectively trading a value of 4 BTC, using 2:1 leverage. Regarding coin Z, you are trading a value of 6 BTC, also with a leverage of 2:1. The entire 10 BTC balance in your account will be used as collateral for both positions.
Let's say the price of ether (ETH) falls, causing a potential loss, but at the same time, the price of coin Z also falls, generating a profit for your short position. The profit from the Z position can be used to cover the loss from the ETH trade by keeping both positions open.
However, if the price of ETH falls and the price of coin Z rises, both of your positions could generate losses. If these losses exceed your total account balance, both positions may be liquidated and you will lose the entire 10 BTC balance in your account. It is a very different scenario from isolated margin, where you only risked 2 BTC that you allocated to the trade.
Remember, these are very simplified examples and do not incorporate trading fees and other costs. Furthermore, real trading scenarios are generally more complex.
Main differences between isolated margin and cross margin
From the above examples, we can clearly see the similarities and differences between isolated margin and cross margin trading. We can summarize the main differences as follows:
Collateral and settlement mechanisms
With isolated margin, you only put a portion of your funds at risk, which is reserved for a specific trade. That is, if you are trading with 2 BTC in isolated margin mode, only these 2 BTC are at risk of liquidation.
On the other hand, in cross margin, all the funds in your account serve as collateral for your trades. If a position moves against your strategy, the system can use your entire account balance to prevent that position from being liquidated. Furthermore, you run the risk of losing your entire balance if multiple trade positions show negative results.
Risk management
Isolated margin allows for more accurate risk management. You can allocate specific amounts you want to risk on individual trades without affecting your remaining account balance. Cross margin, on the other hand, combines the risk of all your open positions. This can be useful when managing multiple positions that can offset each other, but the aggregate risk can also result in more significant losses.
Flexibility
In isolated margin trading, if you want to increase your margin, you need to manually add more funds to that position. On the other hand, cross margin automatically uses the available balance in your account to avoid liquidating any position, making it more practical in terms of maintaining margin.
Use cases
Isolated margin is suitable for traders who want to manage the risk of their trades, especially when they have a high conviction about specific trades and want to keep the risks of each strategy separate. Cross margin is best suited for traders who execute multiple positions that can offset each other (hedging), or for those who wish to leverage their entire account balance while also taking a more hands-on approach to maintaining margin.
Pros and cons of isolated margin
See below the pros and cons of isolated margin:
Pros of isolated shore
Controlled risk: you decide how much of your funds you want to allocate and risk in a specific position. You only risk this specific amount, the rest of your funds remain protected from potential losses related to this trade.
Clearer Profits and Losses (PNL): It is easier to calculate the profits and losses of an individual position when you know the exact amount of funds tied to it.
Predictability: By segregating funds, traders are able to predict the maximum loss they could face in a worst-case scenario, which helps them improve risk management.
Cons of Isolated Margin:
Requires constant monitoring: As only a portion of the funds support the position, it may be necessary to monitor the trade more frequently to avoid liquidation.
Limited leverage: If a trade starts to move against your strategy and approaches liquidation, you cannot automatically use the remaining funds in your account to avoid it. You would have to manually add more funds to the isolated margin.
Management overhead: Managing multiple isolated margins for different trades can be challenging, especially for beginners or those who manage a very large number of positions.
In short, although isolated margin provides a controlled environment for managing risk in leveraged trades, it requires more active management and, in some cases, can limit profit potential if not used judiciously.
Pros and cons of isolated margin
Let’s look at the pros and cons of cross margin:
Pros of Cross Margin
Flexibility in margin allocation: Cross margin automatically uses any available balance in the account to avoid liquidation of any open position, providing more fluidity compared to isolated margin.
Compensating for different positions: Gains in one position can help offset losses in another, which makes this type of margin useful for hedging strategies.
Reduced liquidation risk: By pooling your entire balance, there is a lower risk of premature liquidation for any individual position, as a larger pool of funds can cover margin requirements.
More practical management for multiple trades: cross margin simplifies the process when managing multiple trades simultaneously, as you do not need to adjust the margin for each trade individually.
Cons of Cross Margin
Increased Full Liquidation Risk: 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: Margin is shared across all trades, so it is more difficult to assign a specific risk-reward ratio to individual trades.
Potential for Excessive Leverage: With the ease of leveraging the entire balance, traders may be tempted to open larger positions than they would using isolated margin, which could result in larger losses.
Less clarity regarding risk exposure: It is more difficult to quickly assess risk exposure, especially if there are multiple open positions with different levels of profits and losses.
Example using isolated margin and crossed margin
The joint integration of isolated and cross margin strategies can be a different way to maximize returns and minimize risks in cryptocurrency trading. Let's see how this works on an example.
Let's say you have a bullish outlook on ether (ETH) due to upcoming updates to the Ethereum blockchain, but you also want to hedge against the risks of general market volatility. Do you believe that while ether (ETH) may rise, Bitcoin (BTC) may suffer a decline.
You might consider allocating a specific portion of your portfolio, say 30%, to take a leveraged long ETH position using isolated margin. This way, you are limiting potential losses to this 30% if ETH does not perform as expected. But if ETH appreciates, you could make a significant gain from this portion of your portfolio.
Then, with the remaining 70% of your portfolio, you cross-margin by opening a short position on Bitcoin and a long position on altcoin Z, which you believe will perform well regardless of Bitcoin's movements.
By doing this, you are using the potential gains from one position to offset the potential losses from another. If Bitcoin falls (as you predicted), profits could offset any losses from coin Z and vice versa.
After setting up these positions, you need to continually monitor both strategies. If the value of ETH starts to fall, consider reducing the isolated margin position to mitigate losses. Likewise, if coin Z, in the cross-margin strategy, begins to significantly underperform, consider adjustments to your positions.
By using isolated and cross margins in an integrated way, you actively try to profit from your market predictions and at the same time protect yourself from risks (hedging). However, although combining these strategies helps with risk management, it does not guarantee profits or complete protection against losses.
Final considerations
Margin trading, with its potential to increase profits, also presents an equivalent, or even greater, level of risk. The choice between isolated margin and cross margin comes down to one's trading strategy, including risk tolerance and how actively the investor wants to manage their positions.
In cryptocurrency trading, where volatility plays a significant role, it is critical to understand the intricacies of both types of margin. A well-informed decision, combined with diligence and risk management practices, can help traders face fluctuations in the crypto market. As always, it is essential to do thorough research and, if possible, consult experts before getting involved in margin trading.
Further reading
What is Margin Trading?
What is Leverage in Cryptocurrency Trading?
How hedging works in the crypto market and seven hedging strategies you need to know
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