In the context of trading, you’ll often see the terms ‘leverage’ and ‘margin trade’ being used interchangeably. Very often, they are used in conjunction with cryptocurrency derivatives. Therefore, to understanding leverage in crypto trading, we must understand crypto derivatives. Check out this postfor an in-depth explanation. Here’s a brief for the lazy:
A derivative is a contract between two or more parties where the price is driven by fluctuations in the underlying asset. A crypto derivative, therefore, derives value from the underlying crypto asset, specifically in the form of buying or selling the asset at a prearranged price and specific time in the future.
The following are a few out of the multitudes of designs that they come in:
- Futures: A financial contract where a buyer is obliged to purchase an asset, and a seller to sell an asset. This is done at a specific price and a pre-established future price. All futures have an expiry date that denotes when the buyer and seller of the futures contract settle their outstanding positions.
- Options: Unlike futures, this is a financial contract that is more concerned with the right than the buyer or seller’s obligation.
- Swaps: A swap is an agreement between two parties that are willing to participate in a string of cash flows exchange in the future.
However, it’s largely futures markets that are practically liquid as far as cryptocurrencies are concerned. Now, moving on to our primary focus:
How leverage works
In trading, traders often get to borrow additional funds from an exchange or a broker when trading derivatives, in order to trade underlying assets with the desired exposure. This means you can get leverage on an initial capital that you own. Essentially, leveraging or margin trading allows for opening a trading position with more capital.
Let’s say you want to buy Bitcoin futures expiring 2 months from now, and you have $1000 on your account. But you want to trade Bitcoin with more exposure than the $1000 you have. Let’s say you’re on a margin crypto trading platform, and you borrowed $9000 from an exchange or a broker. In total then, you have $10,000 to trade Bitcoin with. Now you get a much larger exposure to the underlying asset.
With that ratio, you have a 10x leverage, i.e., the actual exposure that you have into Bitcoin would be 10 times your initial capital. You would buy Bitcoin worth $10,000 while your own capital is only $1000. For this post, let’s assume that the cost of one Bitcoin is exactly $10,000. So your capital along with its leverage would enable you to purchase one complete Bitcoin.
How your trade is affected by leveraging
As a concept, leveraging isn’t too complex. The more important thing to understand, though, is the type of effect this borrowed money provides to your trade.
If Bitcoin moves by $10 while you’ve bought it, and you’re on a 10x leverage of borrowed $9000, that would be equal to a $100 move even though you’ve just invested your initial capital. In other words, regardless of the direction Bitcoin moves in, you’d be experiencing 10 times the impact. This would be fantastic if the price always goes in the right direction, but that obviously not always the case, is it?
What are the Downsides of leverage in crypto ?
It’s critical to understand the risk when you’re crypto trading with leverage because the risk dynamics change when the leverage on your trade is higher. If the trade goes in the wrong direction, you will be liquidated i.e forced ejected from your position. If the price goes down enough, your trade position can be canceled without your approval because the exchange has your account as collateral. For them to recover their lent funds, they will eventually close your position and sell your assets. With cryptocurrencies, you may perceive this risk to be higher than in regular capital markets.
Let’s look at another example to understand the downside risks better.
- Let’s say you take on a leverage trade of 10x. So you have your $1000, and you have borrowed $9000 from the exchange. You’re using these $10,000 to buy exactly one bitcoin.
- Now let’s say the price goes down, and it is starting to approach $9000 per Bitcoin. At that point, the only assets you have in your account is the actual Bitcoin that you bought. You’ve used all of your money to buy that Bitcoin.
- Now, the Bitcoin price is approaching $9000, while you also have a loan of $9000 that you took out from the broker. If the broker needs to be paid back, which they do, they need to liquidate your trade to make protect their capital.
- Thus, at around $9000, they will close down your trading position and sell your Bitcoin to recover their $9000. You’ll get whatever’s left, if at all.
Even though the investment just dipped by $1000, you were liquidated at $9000, because that is when you ran out of money. Usually, the exchange will liquidate earlier than that to stay on the safer side because they don’t want to liquidate you on an extremely thin margin. This is what the Delta Exchange does with its Insurance funds for leverage trading.
Another aspect that’s important to keep in mind is that whenever you borrow money, you have to pay interest on the loan. This is true for margin trading as well, and the interest will vary depending on your broker. Sometimes the loan is interest-free if you’re just trading during the day and not holding your trade position overnight. But many exchanges out there have many different kinds of fee setups. You might be charged a commission whenever you trade, or you might have an interest rate that will be taken from your position over time, or you might be charged only if you keep your position overnight.
In any case, do check and be sure of the sort of fee and interest structure your broker has before you start trading on leverage in crypto. Otherwise, you might end up sitting on a position over a long period of time and being charged considerably in fees.
Where does the money come from?
If you go with a 100x leverage on a margin site out there, where does all this money come from? Great question. This can vary based on where you’re trading. Sometimes, the actual broker will supply the loan. In other cases, it might be other investors on the platform. A peer-to-peer structure can allow both lenders and borrowers to be on such a platform, and lenders to give you money for your leverage.
When is it worth the risk?
You either need to be an experienced trade, or start out small with leverage in crypto of, say, 2x. For many people in crypto, that’s good enough. If you think about a housing loan you take from a bank, that’s leveraging your initial down payment by a certain ratio. Only it’s a more secure investment & less volatile than a Bitcoin, and thus the collateral is more stable and long-term. A cryptocurrency trade would be a short-term trade with volatile collateral.
Understanding leveraging in cryptocurrencies while practicing risk management on each trade can prove to be a vital tool in maximizing gains and minimizing losses. It’s more than just observing the direction of your cryptocurrency. Keep an eye out for the market volatility, too, to avoid liquidation of your position, and make sure to keep a wholesome check on your crypto leverage to make the most of your crypto trade. You can also check out this in-depth guide to Bitcoin futures trading when you begin.