Leverage trading in crypto makes it possible to trade a larger amount of crypto without the need to have the full amount of funds required to execute the trade. It is a risky way of trading and a potentially lethal double-edged sword that can multiply both profits and losses.
What is leverage?
Let’s begin by understanding what leverage is in everyday life.
A crowbar used to open crates uses leverage to help force the crate open.
Just using your fingers simply wouldn’t work, the same with a wrench, if you are opening a tight bolt, a wrench makes it much easier or even possible when compared to trying to do it with your bare hands.
This leverage is the force of your hands multiplied. So, in essence, using leverage you could create a lot more force than with your bare hands alone.
Leverage trading has been and continues to be used in equity and commodity trading.
Traders use leverage to allow themselves the opportunity to execute larger trades without the need for the full amount of capital but rather just a fraction of it.
In high-frequency trading, a trader could be moving in and out of stocks or commodities where even relatively small price changes, when multiplied by way of leverage, could be profitable, or of course deadly too!
So, what is leverage trading in crypto?
Now that we understand what leverage is in everyday terms, we can get a better understanding of how leverage can apply to trading.
In the simplest terms, leverage trading could allow you to buy and trade more than you actually have the capital available for.
Let’s say you wanted to buy and trade €10,000 of bitcoin, the important word here is trade, you are not buying the bitcoin as an investment to hold onto, you are buying it for short-term gains with the plan to sell when the price rises.
In this case, it would be possible to buy €10,000 worth of Bitcoin for maybe a down payment of only €1,000.
This would be based on a 10x leverage. Now if your €10,000 of bitcoin becomes €10,500 you make a cool €500 on your €1000 (excluding fees).
A very handsome return! On the other hand, if the price of that same bitcoin drops to €9,500, you lose €500, a 50% loss. A double-edged sword if ever there was one!
How does leveraged trading work in crypto?
Continuing with the above example, let’s say we want to use leveraged trading to buy €10,000 of Bitcoin.
The leverage is 10x to keep things simple. This means that to execute the trade we would need to deposit a margin of €1000 (1/10th of €10,000). Think of this like you are buying a house for €1,000,000 and the bank asks for a 10% deposit (€100,000) and then lends you the rest. If they need to repossess the house and the price has dropped, the initial 10% deposit can hopefully cover any difference in price and expenses.
In much the same way the exchange asks for a deposit and lends you the rest.
The goal of course is for the price to rise, you potentially earn 10x what you could normally with €1000. As with all investing and particularly with something as volatile as crypto, things aren’t always plain sailing. So, what happens if things go south?
The deposit you put down is what is known as an initial margin
This “deposit” is known as the initial margin.
This is what you as the trader would deposit with the exchange in order to be able to execute a leveraged trade.
The exchange will keep the trade open so long as the initial margin covers any losses. This is how an exchange ensures that they are not financially exposed.
It is very important to note that you are trading here and potentially all of your initial margin is at risk.
You are not actually owning any assets. Basically, you are trading, not investing for the long term when you are buying and selling using leverage trading.
If you get close to the edge of your margin limit, you will get what is known as a margin call.
What is a margin call?
If you’ve ever watched films like Wall Street or the TV show Billions you may have heard them talking about a margin call and looking very stressed, it’s when the brokerage is asking for more money to increase your margin or for you to liquidate some of the equity to make more cash available.
Now of course, if you add more money, you have more time but could also sink further into a hole.
Leveraged trading is certainly not recommended for those with a nervous disposition! If things really go south the last resort is something known as a forced liquidation.
What is forced liquidation?
A forced liquidation occurs when the initial margin no longer covers the losses in the trade.
At this moment the exchange forces the liquidation of your account closes out the trade and uses the initial margin, your deposit payment, to cover the losses.
In most cases, forced liquidations would also incur additional costs.
It’s really not somewhere you want to be as a trader!
Smart traders watch their positions carefully and will manually close out a trade before a margin call or forced liquidation occurs, thereby not losing their entire margin and moving on to another trade.
Leverage trading is far away from the cosier world of passive investing!
Leveraged trading is not for the faint of heart or for those with a nervous disposition, however, when used correctly it can allow significantly larger returns on investment (ROI) and not require massive amounts of capital.
In traditional markets when trading stocks or commodities, the price fluctuations can be considered tame when compared to crypto.
This means that leverage trading in crypto is a truly wild beast and open positions need to be monitored even more closely.
Using leverage trading is a pretty risky strategy and could mean big wins or nothing more to show for your trade than a bruised ego and a very dented bank account!