Introduction
Spot vs margin trading: these are different branches of the same ‘tree’ in a financial market. In either case, a trader purchases or sells a financial asset at its current price and hopes to cash out later for a profit.
Yet, margin adds something extra to the deal, a way in which you can bank far more than you usually could.
This is the primary difference in spot trading vs margin trading. However, with risk management in mind, margin is necessary to magnify profits in the shortest period possible.
What is spot trading?
Spot trading describes buying or selling a financial market at its current value for ‘same time’ delivery or execution. This market can be anything like forex, stocks, metals, options, crypto, bonds, etc.
The current value (or the spot price) remains uniform regardless of where you trade the asset.
The main point to understand is that your trading platform executes at the current price after you’ve clicked ‘buy’ or ‘sell.’
Many spot markets involve taking ownership of the traded asset. For example, trading a stock through an exchange means owning the underlying shares. However, we also have spot trading through derivatives.
Here, instead of trading actual shares, you trade a ‘replica’ of the stock while being able to make or lose money with it as you would with the real stock.
So, we have spot trading through physical ownership (or digital ownership in the case of crypto) and derivatives.
Another key component is that spot trading is traditionally unleveraged. In simple terms, it means that you trade on a 1:1 basis. So, if a financial asset costs $1000, you must bring that amount to the table.
Back in the day (before the 21st century), leveraged trading wasn’t common for the average investor. Yet, once markets began branching into non-exchange trading, decentralisation allowed for more freedom and experimentation.
One of these changes was the availability of higher and higher margin.
What is margin trading?
Let’s look at the second part of our spot vs margin trading discussion. Margin is collateral or ‘loan’ offered by a broker to a trader allowing them to open a position much larger than their account balance.
We use leverage and margin interchangeably. Margin is the amount of money you need to open a leveraged position, while leverage is a term that describes having increasing trading power.
In spot trading, you trade on a 1:1 basis. However, depending on the market, you can ‘gear’ your account from a 1:2 to an unlimited ratio with margin.
Now, margin has been around for decades. The reason it’s so popular nowadays is due to capital access.
As a spot trader, you need to commit the total value of a financial asset, whether it costs $100, $10 000 or $100 000. Generally, investing in a market is expensive for the average Joe. So, margin drastically lowers the barrier to entry.
It’s pretty much the only incentive that brokers can offer their clients to trade with them (otherwise, they’d be out of business).
Let’s make an example of a leveraged trade in forex. Assume you wished to trade 2.5 standard lots EUR/USD pair at 1.06060.
Generally, a standard lot on this market is worth $100 000 (so 2.5 lots is $250 000). Let’s also assume that your broker offered a maximum of 1:500 leverage.
Of course, $250 000 to buy currencies is too much money for most people. Yet, 1:500 leverage means that you would only need $500 (250 000 / 500) to have the privilege of trading the same value.
Let’s say a trader decided to sell at the price of 1.06060. If this market fell 10 pips (where each pip is worth $10), this would result in a floating profit of $100.
Yet, if the pair went in the opposite direction, the trader would have a floating loss of $100. We can see that a $100 deficit is 20% of their equity ($500), which is substantial. This is why the cliché of leverage being a double-edged sword remains true.
Differences in spot vs margin trading
The primary distinction between spot vs margin trading is, of course, leverage. This naturally equates to varying degrees of risk. But, at the same time, it’s only the way for traders to make substantial returns.
Let’s go back to our previous example. A $100 profit on a $250 000 balance is a 0.4% increase. Yet, a $100 profit on a $500 account equals a 20% rise. Therefore, margin allows for higher growth with less capital invested.
Needless to say, we have to consider the downside. The higher the leverage, the greater the chances of blowing your account.
This is far less likely when you’re committing the full value of a position as you do with spot trading.
In our last example, if a trader didn’t apply a stop loss, a small 50-pip drop (worth $500) would result in a trader’s account going to zero.
But, the same $500 on a $250 000 account is only a drop in the ocean. A trader could withstand even further losses with this massive balance.
To summarise the differences in spot vs margin trading:
- The capital requirements are higher on spot and lower on margin.
- Leverage is not present with spot but available on margin
Conclusion: which you should between spot vs margin trading?
Earlier, we mentioned that margin is one of the main incentives brokers offer clients. Without this feature, the growth of any traded market is slower.
Due to economic pressures, most of us have no choice but to seek for the biggest returns in the shortest time possible.
Therefore, leverage is necessary to achieve this goal. However, it’s something you should use responsibly. Also, it doesn’t matter whether your leverage is 1:50 or unlimited. Traders are not obliged to utilize the entire ratio.
Spot trading is suitable for wealthier investors looking for slower growth or looking to own physical assets instead of trading derivatives. Also, it is simpler as you don’t have to calculate margin requirements for each position and deal with potential margin calls.
