What is leverage in crypto trading?
Leverage refers to using borrowed capital to trade cryptocurrencies or other financial assets. It amplifies your buying or selling power so you can trade with more capital than what you currently have in your wallet. Depending on the crypto exchange you trade on, you could borrow up to 100 times your account balance.
The amount of leverage is described as a ratio, such as 1:5 (5x), 1:10 (10x), or 1:20 (20x). It shows how many times your initial capital is multiplied. For example, imagine that you have $100 in your exchange account but want to open a position worth $1,000 in bitcoin (BTC). With a 10x leverage, your $100 will have the same buying power as $1,000.
You can use leverage to trade different crypto derivatives. The common types of leveraged trading include margin trading, leveraged tokens, and futures contracts.
How does leveraged trading work?
Before you can borrow funds and start trading with leverage, you need to deposit funds into your trading account. The initial capital you provide is what we call the collateral. The collateral required depends on your leverage and the total value of the position you want to open (known as margin).
Say you want to invest $1,000 in Ethereum (ETH) with a 10x leverage. The margin required would be 1/10 of $1,000, meaning that you need to have $100 in your account as collateral for the borrowed funds. If you use a 20x leverage, your required margin would be even lower (1/20 of $1,000 = $50). But keep in mind that the higher the leverage, the higher the risks of getting liquidated.
Apart from the initial margin deposit, you’ll also need to maintain a margin threshold for your trades. When the market moves against your position, and the margin gets lower than the maintenance threshold, you will need to put more funds into your account to avoid being liquidated. The threshold is also known as the maintenance margin.
Leverage can be applied to both long and short positions. Opening a long position means that you expect the price of an asset to go up. In contrast, opening a short position means that you believe the price of the asset will fall. While this may sound like regular spot trading, using leverage allows you to buy or sell assets based on your collateral only and not on your holdings. So, even if you don’t have an asset, you can still borrow it and sell (open a short position) if you think the market will go lower.
Example of a leveraged long position
Imagine you want to open a long position of $10,000 worth of BTC with 10x leverage. This means that you will use $1,000 as collateral. If the price of BTC goes up 20%, you will earn a net profit of $2,000 (minus fees), which is much higher than the $200 you would have made if you traded your $1,000 capital without using leverage.
However, if the BTC price drops 20%, your position would be down $2,000. Since your initial capital (collateral) is only $1,000, a 20% drop would cause a liquidation (your balance goes to zero). In fact, you could get liquidated even if the market only drops 10%. The exact liquidation value will depend on the exchange you are using.
To avoid being liquidated, you need to add more funds to your wallet to increase your collateral. In most cases, the exchange will send you a margin call before the liquidation happens (e.g., an email telling you to add more funds).
Example of a leveraged short position
Now, imagine that you want to open a $10,000 short position on BTC with 10x leverage. In this case, you will borrow BTC from someone else and sell it at the current market price. Your collateral is $1,000, but since you are trading on 10x leverage, you are able to sell $10,000 worth of BTC.
Assuming the current BTC price is $40,000, you borrowed 0.25 BTC and sold it. If the BTC price drops 20% (down to $32,000), you can buy back 0.25 BTC with just $8,000. This would give you a net profit of $2,000 (minus fees).
However, if BTC rises 20% to $48,000, you would need an extra $2,000 to buy back the 0.25 BTC. Your position will be liquidated as your account balance only has $1,000. Again, to avoid being liquidated, you need to add more funds to your wallet to increase your collateral before the liquidation price is reached.
Why use leverage to trade crypto?
As mentioned, traders use leverage to increase their position size and potential profits. But as illustrated by the examples above, leveraged trading could also lead to much higher losses.
Another reason for traders to use leverage is to enhance the liquidity of their capital. For instance, instead of holding a 2x leveraged position on a single exchange, they could use 4x leverage to maintain the same position size with lower collateral. This would allow them to use the other portion of their money in another place (e.g., trading another asset, staking, providing liquidity to decentralized exchanges (DEX), investing in NFTs, etc.).
How to manage risks with leveraged trading?
Trading with high leverage might require less capital to start with, but it increases the chances of liquidation. Even a 1% price movement could lead to huge losses if your leverage is too high. The higher the leverage, the smaller your volatility tolerance will be. Using lower leverage gives you more margin of error to trade. This is why MoonXBT and other crypto exchanges have limited the maximum leverage available to new users.
Risk management strategies like stop-loss and take-profit orders help minimize losses in leveraged trading. You can use stop-loss orders to automatically close your position at a specific price, which is very helpful when the market moves against you. Stop-loss orders can protect you from significant losses. Take-profit orders are the opposite; they automatically close when your profits reach a certain value. This allows you to secure your earnings before the market condition turns.