Leverage Trading in Crypto: A Beginner's Guide

This article aims to demystify the topic of leverage trading, particularly regarding crypto markets, although much of the same applies to traditional markets. With this piece, newcomers can better understand how it works.

Basics

Leverage in crypto trading refers to controlling a large amount of capital using much smaller money and borrowed funds. It allows traders to increase their buying power and profit from smaller investments. By taking on greater risk, traders can use leverage to magnify the profits they receive from their trades.

Using leverage, traders can increase their buying or selling capacity in the cryptocurrency market. For example, users can get up to 100 times their available balance depending on the exchange. Borrowed capital allows them to increase their trading power despite having limited capital in a personal wallet.

The leverage ratio can be presented as a fraction, such as 1:5 (5x), 1:10 (10x), or 1:20 (20x). This ratio shows how many times your initial capital is amplified. For example, if you only have $100 in your exchange account but wish to invest $1,000 in BTC, opting for 10x leverage will give your $100 the same buying power as $1,000.

Trading crypto derivatives is doable with leverage. The most popular leverage trading methods are margin trading, leveraged tokens, and futures contracts.

What Are the Principles Behind Leverage Trading?

Before you can partake in high-leverage trading, you'll need to deposit funds into your trading account that serve as collateral. The amount required depends on the level of leverage involved and the size of the position you're looking to enter (known as margin).

If you plan to invest $1,000 in ETH and want to use leverage to increase your trading volume, you must know that you must have a certain amount of money available as collateral. For 10x leverage, you will need $100 of your funds in your trading account, while 20x leverage would require only $50. However, it is essential to remember that more leverage implies an increased liquidation risk.

In addition to your initial margin deposit, you must maintain a minimum margin level for your trades. If the value of the market goes against you and your margin falls below the minimum required (known as the maintenance margin), you need to add more money to your account so it won't be liquidated.

Engaging in leverage can be advantageous or disadvantageous, depending on whether you open a long or short position. Long positions involve expecting the value of an asset to rise, while short positions indicate a belief that the price of an asset will drop.

Leveraged trading differs from spot trading since it allows you to enter a transaction by only providing collateral, not the actual asset. This means that even if you don't own the asset, you can still gain access to it through borrowing and creating a short position if you anticipate a price decline.

A leveraged long position is when an investor borrows money from a broker to purchase a security, expecting the price to rise. This allows the investor to own more shares than they can afford with their capital and reap more significant profits when the security increases in price.

Example of a Leveraged Long Position

If you use leverage to increase your exposure in a BTC long position, you can trade with $1,000 of collateral to open a $10,000 position. If the price of BTC rises by 20%, your net profit (minus fees) will be $2,000 – much higher than the $200 you would have earned on the same capital balance without leverage.

If bitcoin prices were to drop 20%, you would experience a total loss of $2,000 in your position. Your original collateral of $1,000 would be inadequate, and a 10% drop could even put you at risk of complete liquidation (reaching a zero balance). Depending on your exchange, the amount you would face liquidation may vary.

To avoid liquidation, you must ensure your wallet has sufficient funds to maintain suitable collateral coverage. Usually, before liquidation occurs, an exchange will send you a margin call (e.g., an email alerting you to add more funds).

Example of a Leveraged Short Position

A leveraged short position is when an investor borrows a security from a broker and immediately sells it, planning to return the security and repay the broker later. The investor profits if they can repurchase the security at a lower price than they sold it.

To open a $10,000 short position on BTC with 10x leverage, you must borrow BTC worth $10,000 from another party and sell it at the market price. The collateral for this transaction is $1,000, and with 10x leverage, you can effectively sell $10,000 worth of BTC.

If you borrow 0.25 BTC at the current BTC price of $40,000 and sell it, you can buy back the same amount for a lower price if the value decreases by 20% to $32,000. Doing this would mean you get 0.25 BTC for only $8,000, making you a net profit of $2,000 (minus fees).

If the price of BTC increases by 20% and reaches $48,000, you will need an additional $2,000 to repurchase the 0.25 BTC. Your position would be terminated with only $1,000 in your account balance. To avoid liquidation, you must top up your funds to raise your collateral above the liquidation level.

Why Do People Use Leverage?

Using leverage to trade crypto can significantly maximize your potential gains while granting you greater flexibility in your trading strategy. Leverage can open up new opportunities to novice and experienced traders, allowing them to mitigate the risks associated with volatile markets by allowing them to open larger positions for a given capital investment. With leverage, traders can also make more aggressive trades on margin, potentially increasing their profits if their trades succeed.

Traders often use leverage to magnify their position size and, consequently, their potential profits. However, this same leverage can lead to much more significant losses than usual, as the examples above have outlined.

Traders leverage their capital to increase their liquidity. For example, instead of maintaining a 2x leveraged position on a single exchange, they may choose to use 4x leverage, allowing them to keep the exact position size while needing less collateral. This would allow them to invest the remainder of their funds in alternatives such as trading a different asset, staking, providing liquidity for DEXs, and purchasing NFTs.

Tips for Managing Leverage Trading Risks

Using high leverage in trading can require less money upfront, but this comes with increased liquidation risks. The higher the leverage is, the less you can tolerate fluctuations in price, which could lead to disastrous results should prices only fluctuate by 1%.

Lowering one's leverage provides a larger buffer of safety. Because of this, many crypto exchanges cap the leverage levels accessible to rookies.

Risk management strategies such as stop-loss and take-profit orders can reduce losses from leveraged trading. Stop-loss orders are especially useful, as they will close your position at a predetermined price if the market moves against you. This type of order can help to safeguard you from significant losses. In contrast, take-profit orders work to close your position when your profits reach a certain amount, thus allowing you to capture your profits before the market trend changes.

Trading with leverage can significantly increase your potential gains, but it can also lead to significant losses. Due to the unpredictable volatility of the crypto market, exercising caution when utilizing leverage is imperative. 

Traders should always exercise caution when placing trades and use tools like the anti-addiction notice and cooling-off period function to help them keep control. Additionally, they should never forget to 'Do Your Own Research' (DYOR) to understand how to use leverage and properly plan their trading strategies.

Conclusion

Leverage offers the advantage of starting trading with a small initial investment and the possibility of increased earnings. However, leverage paired with market volatility could lead to the sudden closure of a position, particularly if you are leveraging 100x. When trading, exercise caution and carefully weigh the risks. Never invest money you cannot afford to lose, especially when using leverage.