What is Leverage in Crypto Trading?
For many beginners, trading with leverage can seem complex and bewildering. It's crucial to understand the principles of how leverage works before deciding to invest your funds. In this article, we will focus on explaining the principles of trading with leverage in the cryptocurrency market, but much of this information will also be relevant to those interested in traditional financial markets.
What Is Leverage in Cryptocurrency Trading?
Leverage in cryptocurrency trading refers to a mechanism that permits traders to utilize borrowed funds when dealing with cryptocurrencies and other financial assets. This approach enhances a trader's capacity to buy or sell by enabling them to execute trades with more substantial volumes than their account balance. Depending on the cryptocurrency exchange, traders can potentially borrow sums that surpass their own balance by a factor of 100 or more.
The extent of leverage is typically represented as a ratio, for instance, 1:5 (5x), 1:10 (10x), or 1:20 (20x), denoting how much the available trading capital is augmented. To illustrate, if a trader possesses $100 on a particular exchange and wishes to initiate a position valued at $1000 in a cryptocurrency like Bitcoin (BTC), with 10x leverage, their $100 transforms into $1000, allowing them to execute such a trade.
Additionally, leverage can also be employed for engaging in diverse cryptocurrency derivative trading methods. Typical varieties of leverage-driven trading encompass margin trading, leveraged tokens, and futures contracts.
How Leverage Trading Works
Trading with leverage involves a series of fundamental steps. To begin, a trader needs to deposit funds into their trading account, enabling them to access borrowed capital. This initial deposit, referred to as collateral or margin, varies depending on the chosen leverage level and the total position value the trader intends to establish.
For instance, if a trader wishes to invest $1000 in Ethereum (ETH) with a 10x leverage, the required margin would be 1/10 of $1000, which equals $100. This means that the trader must maintain $100 in their account as collateral to utilize the borrowed funds. With a 20x leverage, the margin requirement would be even lower (1/20 of $1000 = $50). However, it's essential to keep in mind that higher leverage also escalates the potential risks associated with position liquidation.
Apart from the initial margin deposit, a trader must also uphold a margin maintenance level for their trades. Should the market move unfavorably against the open position and cause the margin to fall below the maintenance level, the trader must inject additional funds into their account to prevent position liquidation. This maintenance threshold is also known as the margin maintenance level.
Leverage can be applied to establish both long and short positions. A long position signifies the anticipation of an asset's price increase, whereas a short position involves forecasting a price decline. While this may seem akin to regular trading, leverage empowers the trader to purchase and sell assets based on their collateral, even in the absence of available funds to execute the trades. Consequently, a trader can borrow assets and execute sales (open short positions) when they foresee a price drop.
Long Position Example with Leverage:
Let's consider a scenario where you decide to initiate a long position in Bitcoin (BTC) with a value of $10,000 and 10x leverage. In this instance, the required initial deposit, known as collateral, would amount to $1,000. If the price of BTC rises by 20%, your net profit would reach $2,000 (after accounting for fees). This is a significantly higher return compared to the $200 profit you would have made through regular trading without leverage.
Nevertheless, if the BTC price experiences a 20% decline, your position would incur a loss of $2,000. Given that your initial capital (collateral) is just $1,000, this would result in the liquidation of your position, effectively reducing your account balance to zero. It's worth noting that liquidation can occur even if the market witnesses a mere 10% decrease in value. The specific liquidation threshold is determined by the rules of the exchange.
To prevent liquidation, you would need to inject additional funds into your account and raise your collateral level. Most exchanges offer margin calls, which are notifications of insufficient funds, typically delivered through means such as email, prompting you to top up your account.
Short Position Example with Leverage:
Suppose you wish to establish a short position in Bitcoin (BTC) valued at $10,000 with 10x leverage. In such a case, you would need to borrow BTC from another party and sell it at the current market rate. The collateral requirement would stand at $1,000, and with 10x leverage, you would be able to sell BTC for $10,000.
Let's assume that the current price of BTC is $40,000. You decide to borrow and sell 0.25 BTC. If the BTC price experiences a 20% drop to $32,000, you would be able to repurchase 0.25 BTC for just $8,000, leading to a net profit of $2,000 (after fees are factored in).
However, if BTC surges by 20% to $48,000, you would need to deposit an additional $2,000 to buy back 0.25 BTC. If your account balance dwindles to $1,000, the position would undergo liquidation. To avoid this scenario, you would have to deposit extra funds into your account and elevate your collateral to meet the liquidation threshold.
Why Use Leverage in Cryptocurrency Trading
Traders employ leverage to increase the scale of their positions and amplify potential profits. However, as previously demonstrated, utilizing leverage also carries the risk of substantial losses.
Another reason for using leverage is to enhance the liquidity of accessible funds. For instance, instead of holding a 2x leveraged position on a single exchange, you can opt for 4x leverage to maintain the same position size with reduced collateral expenses. This provides the opportunity to allocate a portion of funds for alternative purposes, such as trading different assets, engaging in staking, offering liquidity on decentralized exchanges (DEXs), investing in NFTs, and more.
Risk Management in Leveraged Trading
Utilizing a high level of leverage can enable you to trade with a small initial deposit but also increases the risk of liquidation. If your leverage is too high, even a small price change, as little as 1%, can lead to significant losses. The higher the leverage, the more vulnerable you become to market volatility. Reducing your leverage can serve as a means to protect yourself from substantial losses in case of trading errors. This is one of the reasons why many cryptocurrency exchanges, including Binance, impose limits on the maximum leverage for new users.
To manage risks while trading with leverage, it's helpful to employ strategies such as stop-loss and take-profit orders. Stop-loss orders can be set to automatically close positions when the price reaches a specified level. This is particularly useful when the market moves against you and helps protect your funds from substantial losses. Take-profit orders, on the other hand, automatically close positions when the profit reaches a predefined level, allowing you to secure your earnings as long as market conditions align with your strategy.
It's essential to understand that trading with leverage is a strategy associated with high risks, especially in the cryptocurrency market known for its volatility. Therefore, Binance and other platforms strongly advise traders to exercise caution, make responsible decisions, and utilize available risk management tools. These tools may include loss control notifications and temporary lockouts. Always exercise caution and conduct your research to effectively use leverage and develop your trading strategies.
In conclusion, leverage is a tool that allows you to start trading with small initial investments and potentially increase your profits. However, it's essential to remember that when using leverage on volatile markets, there is a high risk of rapid liquidation, especially when employing high levels of leverage, such as 100x. Always exercise caution and make a sober assessment of risks. Trade only with funds you are willing to lose, especially if you plan to utilize leverage.