Traders, investors, and companies are always looking for new ways to increase their profits, so they grab any chance that comes their way. As a result, despite the hazards associated with some of these choices for increased profit, many traders nevertheless find the bravery to examine them. Many cryptocurrency brokers provide leverage options, some with absurdly high leverage ratios and others with just enough. Leverage has been around for a while in the world of trading, and it’s perhaps the most promising of all the ways to make more money, but it’s not without its risks.
What is leverage trading?
It refers to using borrowed capital to trade cryptos or other financial instruments. It increases your purchasing or selling power, allowing you to trade with more money than you have in your wallet. You could borrow up to 100 times your account balance depending on the crypto exchange you use. Different crypto derivatives can be traded with leverage.
The popular examples of leveraged trading include margin trading, leveraged tokens, and futures contracts. Leverage is expressed as a ratio, such as 1:5 (5x), 1:10 (10x), or 1:20 (20x) (20x). It displays the number of times your starting capital has been multiplied.
How does leverage trading work?
You must first deposit funds into your trading account before you can borrow funds and start trading with leverage. We refer to the initial capital you offer as collateral. The amount of collateral you’ll need is determined by the amount of leverage you’re using and the overall value of the position you intend to open. Let’s say you wish to put $1,000 into Cardano (ADA) with 10x leverage. The needed margin is 1/10 of $1000, which means you must have $100 in your account as security for the borrowed funds.
You’ll need to have a margin threshold for your trades in addition to the initial margin deposit. If the market moves against you and your margin falls below the maintenance barrier, you’ll need to put in more funds to keep it from being liquidated. Before the liquidation, the exchange will most likely give you a margin call; for example, an email will be sent telling you to add more funds.
Another way traders employ leverage is by increasing their capital’s liquidity. For example, instead of having a 2x leveraged position on a single exchange, they may hold a 4x leveraged position with less collateral. This would allow them to put the rest of their money to better use (for example, trading another asset, staking, giving liquidity to DEXs, investing in NFTs, and so on).
When you open a long position, you’re speculating that the price of the cryptocurrency will rise.
Assume you wish to open a $10,000 long position in Ethereum (ETH) with a 10x leverage. It means you’ll put up $1,000 as collateral. If the price of ETH rises 20%, you’ll make a net profit of $2,000 (without fees), which is far more than the $200 you’d get if you traded your $1,000 money without leverage.
If the ETH price drops 20%, your stake will lose $2,000 in value. Because your initial capital (collateral) is a mere $1,000, a 20% loss will result in liquidation. However, the actual liquidation value will be determined by the exchange you use.
When you open a short position, you’re betting that the cryptocurrency price will fall.
Consider the following scenario: you wish to open a $10,000 short position on Ethereum with a 10x leverage. You’ll borrow ETH and sell it at the current market price in this situation. Your collateral is $1,000, but you can sell $10,000 worth of ETH because you’re trading with a 10x leverage.
You borrowed 0.25 ETH and sold it at the current ETH price of $40,000. If the price of ETH decreases 20% (to $32,000), you may repurchase 0.25 ETH for only $8,000. This would result in a $2,000 profit (without fees).
If ETH rises 20% to $48,000, you’ll need an additional $2,000 to purchase back the 0.25 ETH. Your position will be liquidated because you have $1000 only in your account.
Risks of leverage and how to manage it
The appeal of leveraging your gains to multiply your profits can be lucrative. Meanwhile, there is always a considerable level of risk when trading crypto on margin. Keep in mind that the larger the leverage you utilize, the lesser the margin of error you have when it comes to reaching your liquidation threshold. In certain circumstances, a 1% difference in price is all it takes to be liquidated and lose a significant amount of money. Also, because of the frequent rapid fluctuations in the crypto market in both positive and negative directions, it adds another degree of risk.
Some risk-management measures to employ to help reduce your risk.
- Always take profits and never trade with more money than you cannot afford to lose.
- Use of stop-loss. Stop-loss is a risk-management technique that closes your trade at a predetermined price if the market swings against you.
- Trading with smaller sums reduces risk and prevents you from losing all of your money in one transaction.
- Using lower leverage allows you to keep more money in your account and open more deals.
- Negative balance protection is a risk-management method offered by some trading platforms. It prevents you from losing more money than you have. If your account’s capital turns negative as a result of the leverage, the lending platform agrees to bear the loss.
Leverage is a profit or loss multiplier. It’s a good idea to start with a demo account to gain experience with technical analysis and market movements. Knowing when and when not to use it is one of the secrets to becoming a master of leverage trading. Leverage has long been a popular financial asset, and gaining skills on how to use it might help you save money. You should also improve your understanding of risk-management tactics and trading methodologies.