Trading

Leverage is a common but often misunderstood concept in crypto trading. Read all about it here.

In the market, it’s common to “throw a sprat to catch a herring.”

Take housing mortgages as an example: For a $1 million house, the buyer makes a $100,000 down payment, borrows $900,000 from the bank and pays interest for bank loans.

Similarly, a company with insufficient capital may choose to use borrowed capital for production, so as to boost its returns. However, this also increases the risks — if the business isn’t performing as well as planned, the company will have more debts than assets.

To put it simply, leverage is the use of borrowed capital to amplify one’s buying or selling power to open a bigger trade position.

As mentioned earlier, leveraged cryptocurrency trading means using borrowed capital to amplify your buying or selling power. This allows traders to open larger trading positions than the capital they have in their wallets. Depending on the exchange used by traders, they’re able to make use of leverage up to more than 100x of their account balance.

In addition, using leverage allows traders to buy or sell assets even if they don’t hold that leverage. They can open a long or short position for the cryptocurrency based on the collateral that has been deposited.

Leverage is often used by traders to obtain larger profits. However, it should be noted that greater leverage corresponds to a higher chance of being liquidated. More details on this will be shared in the later part of this article.

Before starting to use leverage, a trader needs to fund their trading account. This initial capital that’s being deposited into the trading account is known as collateral. Depending on the leverage, total value of the position that the trader wants to open and type of cryptocurrency, the required collateral (also known as margin) varies.

The amount of leverage that a trader can tap on is more often than not expressed as a ratio. A 1:10 leveraged position indicates that the trader will multiply their position size 10x. Let’s look at an example to understand better. 

If a trader wishes to invest $1,000 in Ethereum with 10x leverage, the margin required would be 1/10 of $1,000. This means that simply by depositing $100, a trader will be able to open a $1,000 position on Ethereum. But if the trader wishes to use 20x leverage, the required margin would be even lower, calculated by 1/20 of $1,000 = $50. However, it’s important to note that higher leverage is accompanied by higher risk of 

. This is when the exchange which the trader is using takes over the collateral in the trader’s trading account.

The trader will have to pay interest on the borrowed funds and losses incurred on the leveraged position. Hence, you need to be cautious as to how much leverage you’re taking, as it could result in very high interest and offset the profits earned from a trade.

Once a trader has deposited the initial margin, they’re required to maintain a margin threshold. If the market moves drastically in the opposite direction from the trader’s position, the margin might fall below the margin threshold (also known as maintenance margin), which will put the trader at risk of liquidation. In such scenarios, the trader will be required to deposit more funds to maintain the margin threshold and avoid liquidation.

By using leverage, you can increase your exposure to cryptocurrencies. If you’re certain of the direction a cryptocurrency will be taking, you can open either a very large long or short position on it without having to fork over such a large sum of capital. Should the market move in the predicted direction, you stand to profit handsomely from the trade.

Leverage allows traders to allocate their limited capital to other aspects of the crypto market, such as staking and liquidity provision, to earn yields on their capital.

Likewise, leverage may offer a practical option when one doesn’t have enough money to buy $50,000 worth of equity in the stock market.

Suppose we want to buy Stock A with a minimum lot size of $500, but we only have $100. What should we do?

It may have already occurred to you that you can use higher leverage to buy the same number of shares with less capital, as the trader in Example 1 would need only $50 to purchase $500 worth of stock at 10x leverage.

Trading fees and interest paid/received are decided by the notional amount in derivatives contract trading. As we’re trading $1,000 anyways, we’re paying the same fee and interest. Why don’t we use higher leverage and pay less margin? If the price of Stock A goes up, as you expected, then congratulations! You’ve made a good deal! However, if the price goes down — well, higher leverage comes with accelerated liquidation. 

Of course, if leverage isn’t used in trading, even when the share price plummets from $100 to $1, you can still get your $1 back by selling your shares or continuing to hold them.

In leveraged trading, when your position margin declines to the maintenance margin threshold, you’ll receive a margin call or be liquidated. To avoid liquidation, you may use lower leverage. From the second example, we can see that the lower the leverage, the higher the amount of margin required, and the greater the buffer from liquidation.

Let’s run through a more detailed example of how to use leverage.

A trader begins by depositing collateral into their cryptocurrency exchange trading account. Presuming a trader has deposited $5,000 into their trading account and is looking to open a long position on Ethereum, a 5x leverage position will give the trader access to $25,000.

With 5x leverage, the price of Ethereum moves 5x more than the spot market. If Ethereum’s price increases by $100, the trader will have a profit of $500, and vice versa: If Ethereum’s price drops by $100, the trader’s account will be down by $500. Hence, should Ethereum’s price keep dropping, it will reach a point where the trader has no margin left in their trading account. This will trigger liquidation of the trader’s entire account, and all collateral will be lost.

Suppose we have $8,000, and the last traded price of BTC is $8,000.

As mentioned earlier, there are risks to using leverage.

Beginners who have just joined the cryptocurrency market — as well as investors who are looking to hold cryptocurrencies for the long term — should not be employing leverage in their strategies. The same can be said for passive investors, as using leverage requires one to pay constant attention to the margin threshold in order to prevent liquidation. 

Given the volatile cryptocurrency markets, one’s trading account might be subjected to liquidation when the market moves in the opposite direction as the position. This risk is higher when higher leverage is used, and your account could be entirely wiped out even if the market moves only slightly.

When a trader’s account is at risk of liquidation, they will typically receive a margin call, which is a warning that the account’s collateral is running low and is at risk of liquidation. When faced with such a situation, one can choose to add more collateral to the account to avoid liquidation. 

There are also risk management methods you can employ to curb this downside of leverage.

Before entering a position, a trader should calculate their risk/reward ratio. This will give the trader an understanding of how much margin requirement is required to achieve the desired profit. After doing this, the trader can set stop-loss and take-profit levels for their trades. A stop-loss will automatically close the trading position at the stipulated level, preventing excessive loss or liquidation. A take-profit, on the other hand, will help the user to take profit and close the trading position, preventing a scenario where the markets reverse and the trader loses out on their gains.

Leverage is a double-edged sword: while your investment is augmented, so is your risk. The use of leverage can be satisfying if the market moves as expected, but the reverse is also true if it doesn’t!

Moreover, leverage increases the volatility of the cryptocurrency market. This is because when a large number of traders get liquidated, a large number of assets are wiped from the markets, resulting in large price spikes in the market.

Always practice risk management, and add stop-losses and take-profits where applicable to protect your account from liquidation.

What Is Leverage in Crypto Trading? (A Simple Explanation)

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