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Today’s “Long Story Short” discusses how to calculate your optimal margin for delta one cryptocurrency products. Kollider’s series is purely educational and not investment advice. Please do your own research.

90% of your trading profits will come from 10% of the tiny details that everyone else ignores. Maybe that’s an exaggeration, but the truth is likely not too far off. In trading, nuances really, really matter. One of those seemingly microscopic details is margin.

Optimise your margin use, and you could increase returns by double digits. In the event you get it wrong, you could be liquidated and your P&L could be zeroed out. It’s a tricky balance, but finding the amount that works for your trade can make the difference between a mediocre strategy and a stellar one.

So, how do you determine the correct margin quantity for your strategy?

# What Role Does Margin Play?

When it comes to derivatives, margin is the collateral required for opening a position. But margin can be much more than that. It can define the balance between capital efficiency and safety. We’ll demonstrate this with a contrived example.

Imagine you had a strategy that made you 1 bitcoin. If you used 1 bitcoin as margin for the trade, your return was 100%. Given the collateral used, the liquidation price is further away, but capital efficiency is low.

Instead, if you were able to leverage and only use 0.5 bitcoin while becoming more capital-efficient, your return would have been 200%, and so on. The safety, however, is low, since if you did not use enough margin and your position gets liquidated, your return is now -100%.

Leverage and margin are closely intertwined when trading derivatives, and each affects the other. So in a world where you can trade with leverage up to 100x (1:100), how should you optimise margin use?

# How To Calculate the Optimal Margin

In most cases, your position will have some risk of getting liquidated. If that probability is too high for comfort, then your margin is too low. For now, let’s assume that we want to have a very low chance of getting liquidated. This condition allows us to calculate a specific margin boundary in three steps:

1. Decide on your strategy’s absolute maximum position. Your liquidation point is effectively when your position’s unrealised loss has matched your remaining margin, and the maximum position helps determine what you could lose. Note that the liquidation point described here is simplistic, as there are more considerations like maintenance margin.
2. Find the largest probable price percentage change you could experience. To be as safe as possible, we would take our assumed longest holding time as our worst-case scenario. For example, say we would not be in our max position longer than one hour. We can then look at all the one-hour periods in the past and determine the maximum price movement that can occur.
3. Calculate your max potential loss. We can calculate this by calculating the unrealised P&L using the max position and the largest probable price % change above. Calculating P&L varies for each type of product, but each exchange will usually show you how to calculate the P&L for their offerings.

Let’s work through an example. Suppose our strategy is trading leveraged spot BTC/USD and can take on a max position of 3 BTC. By going back through several months’ worth of one-hour bars, we find that the largest price change is 50%. This would tell us that we could potentially lose as much as 3 BTC × 50% or 1.5 BTC in a single one-hour holding period.

This gets us back to the question of balance. In the scenario above, if we had fewer than 1.5 BTC in our margin account, we would increase our risk of getting liquidated. Increasing to or above 1.5 BTC significantly reduces the risk of liquidation. However, we start to pay for that safety with lower returns, and we start to incur opportunity cost.

Therefore, 1.5 BTC remains our concrete boundary, but you are free to move around that number based on your own comfort level. Similarly, you may also believe volatility will change in the future. While the historical data in the example above may have shown a 50% price move in a single hour, you might believe that bitcoin is stabilising and will have smaller single-hour price changes going forward.

Even with the calculated boundary, what margin quantity you ultimately choose is up to your personal tolerance. You may be comfortable taking on more risk for a higher potential return, or vice versa. Regardless of what you decide, you now have the framework to decide between capital efficiency and safety.