What’s leverage?
Leverage is a common investment strategy used in multiple financial markets like stocks, commodities, and also cryptocurrency. It refers to the practice of borrowing funds instead of using your own capital for trade with the expectation of increasing the possibility of greater returns. While leverage allows traders to acquire more assets and thus more profit with limited funds, it also increases the chance of making an equally big loss. A ‘highly leveraged’ company, property, or asset shows that the item in question has less equity and more debt.
Both individual investors, as well as organizations and companies, use leverage. While investors do so to boost profits, firms tend to use leverage to finance assets. When they use debt financing rather than issuing stock to raise more capital, it also increases shareholders’ value.
Leverage in crypto
In the cryptocurrency market, leverage is the capital you borrow to trade cryptocurrencies such as Bitcoin, Ethereum, Dogecoin, etc. Even if there are limited funds in your wallet, your purchasing power, as well as your ability to sell, can be boosted with leverage. While the leverage you get could vary from one crypto exchange to another, you can borrow over 100 times your account balance.
The proportion of leverage you can avail is indicated as a ratio like 1:5 (5x), 1:10 (10x), or 1:20 (20x). This ratio denotes how many folds your initial capital could increase with the funds you borrow. So say for instance your wallet has $100 but you still want to buy bitcoin worth $1000, you can use a 10x leverage to make that purchase.
Even crypto derivatives can be traded with leverage. Popular trading with leverage crypto types are margin trading, leveraged tokens, and futures contracts.
How does leverage work?
Prior to borrowing funds and trading with leverage, you must add funds to your trading account. This initial capital to get started is known as collateral. How much collateral you would need would rely on the leverage you want to use as well as the margin which is the final value of the position you open.
Let’s understand this with an example. Assume that you wish to make an investment of $1,000 in Shiba Inu coin and use 10x leverage for this. So the margin you need will be 1/10th of $1,000 and hence the collateral or the balance in your account should be $100. If the leverage you use is 20x, you would need $50 as margin.
Do remember that greater leverage implies a greater risk of having your assets liquidated.
The collateral or the margin deposit is enough to get you started but you must also keep a maintenance margin handy for when the market movements are not in your favour. In such a situation the margin would be lesser than your maintenance threshold and thus, you would have to add more funds. If you do not do so, your assets will risk being liquidated.
Both long and short positions (link shorting article) can be boosted using leverage. While a long position shows that your money is riding on the possibility that the market will go up while a short position indicates that you’re hoping for a drop in asset prices. Even though this could appear very similar to spot trading, buying or selling assets in the crypto markets depends only on your collateral and not holdings. Hence, you may borrow or sell an asset even if you don’t have it if you predict that the prices will take a hit.
What good is leverage?
As mentioned, traders use leverage to increase their position size and potential profits. But it could also lead to much higher losses.
As we discussed earlier, traders make use of leverage to increase their profits by going for bigger position sizes. So rather than holding a position at 2x leverage on just one exchange, a crypto trader may choose to use 4x leverage to keep the same position but with a lower margin. This would free up their capital that may be used for different assets like NFTs, staking, trading another asset, etc.
Levered vs Unlevered Trading
There are two types of trading that you can explore: levered and unlevered trading.
Let’s take an example where the last traded price of a bitcoin was $8,000. The following day, it goes up and moves to $8,050. For unlevered trading, you buy one BTC and sell it to make a profit of $50. When you use levered trading, you spend $80,000 to buy BTC at $8,000 each and then sell them to make a profit of $500 with a 10x leverage.
Risk management in leverage trading
The starting capital with leverage trading may be less but the chances of liquidation are high. Hence, if you’re using very high leverage, just a 1% price movement can cause significant losses. Another major disadvantage of greater leverage is that it decreases your trade’s ability to stand volatility which is important in a market as volatile as crypto. Lower leverage allows you to access more margin of error to trade.
Effective strategies to manage risks, such as stop-loss orders, and take profit orders can keep your capital safe with leveraged trading. Stop-loss orders can help you determine a point of exit when the market movements are not in your favour while take-profit orders secure your profit before the market’s mood changes.
Consider leveraged trading as a risky gamble of sorts where you have an equal chance of earning and losing more. There’s a significant amount of risk involved, particularly in a market as volatile as the cryptocurrency market. We strongly recommend understanding the market and its functions that will enable you to make wise trading calls.
Closing thoughts
Leverage can be an advantage if you want to start with a small investment that develops the potential to earn greater returns for you. Yet, as a crypto trader, you should always be mindful of the fact that leverage in a highly volatile market could speed up liquidation particularly when you’re tempted to take a 100x leverage. Always remember to use leverage carefully–don’t be tempted to trade more funds than you can afford to lose.
