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understand how leverage trading works
Educational
November 16, 2019

What is Leveraged Trading? – The Complete Guide for Cryptocurrency Traders

Jitender TokasChief Business Officer

At Delta Exchange, we offer leveraged trading products for our customers. When used correctly, leverage can revolutionize the way you trade, maximizing profits and allowing you to take larger positions in your cryptocurrency of choice.

However, although leveraged trading is a popular tool in foreign exchange markets and sometimes CFD stock trading platforms, its widespread use in crypto is still a novel concept for many traders entering this nascent market. Here, we’re going to demystify the process of leverage trading and show you how trading with leverage can potentially amplify your trading gains.

Why Would You Choose to Use Leverage?

Leverage trading opens a range of possibilities for the average and professional trader which wouldn’t normally be available to them. Principle among these advantages is the ability to realize greater gains in proportion to the amount of trading capital, or margin, that a trader has.

In addition, margin accounts are useful for short selling of a cryptocurrency asset. Essentially, short selling is when a trader hopes to profit from the declining price of a digital asset. For example, when the price of Bitcoin fell from its early 2018 highs, those who ‘sold short’ would have realized huge gains – especially had they done so with leveraged positions.

The combination of ability to go long or short and trade with leverage can enable a trader to profitably navigate all market conditions. Thus, it is important to learn the basics of leverage trading. One easy way to get a hands on practice of leveraged trading is to open an account on Delta Exchange’s testnet and learn through mock trading.

How Does Leverage Increase Your Position?

You’ll often hear the words margin and leverage used almost interchangeably within cryptocurrency trading circles, although these two concepts have distinct meanings despite their close relationship. Essentially, we can think of margin as being used to ‘create’ leverage.

As we’ve explored, leverage is the term often applied to how much a trader can borrow to increase their open positions. On the other hand, margin is how much a trader needs to deposit in good faith to keep the position open, relative to the level of leverage required. We often measure leverage in ratios, as this represents your borrowed capital versus your initial margin.

Let’s look at a simple example. Say that you would like to trade Bitcoin on Delta Exchange, and you want to get started with just 0.01 BTC. In this instance, the 0.01 BTC deposited by you would be your margin. As Delta Exchange allows for 100x leverage, you could trade 1 whole BTC with a margin of just 0.01 BTC – this then dictates your leverage ratio. In this scenario, your leverage ratio is 100:1. In other words, you can trade with capital one hundred times greater than your margin.

This is a simple concept to remember, but the relationship between margin and leverage becomes more complex when we consider other factors such as margin calls, liquidation, and the costs associated with keeping a position open.

So, how can we calculate how much you would earn in an open position where the market was moving in your favour? To do this, we would calculate the ‘Return on Equity’, or ‘RoE’. To arrive at an RoE value, we can take our profit minus any losses we have incurred, expressed as ‘PnL’ – profit net loss – and multiply this by our leverage amount. It’s clear to see that utilizing leveraged trading can significantly increase your gains, but remember if the underlying asset’s value is moving against you, it will also increase your loses and put you at risk of liquidation.

Let’s take two scenarios of a trade, one without leverage and one with leverage.

Scenario 1 – Without Leverage

X trader wishes to buy 1 Bitcoin at the price of $10000. For such a traditional trade, X would have to deposit $1000 in his account and only then would he be able to buy the bitcoin. If the price of a bitcoin goes up by 5% to $10500 X has made a profit of $500.

Return on Equity = $500/$10000

=0.05 or 5%

Scenario 2 – With Leverage

X trader wishes to buy 1 Bitcoin at the price of $10000 with a 10:1 leverage. For a leveraged trade, now X would have to deposit $1000 as against $10000. The remaining money has been borrowed from the exchange to enter into the trade. Now when the Bitcoin price goes up by 5%, X has made the same profit of $500 but the return on equity is multiplied as the money deposited was only $1000.

 

Return on Equity = $500/$1000

=   .5 or 50%

On Delta Exchange, one can take leverage up to 100x for a particular trade. This means that, even though the amount deposited in your account can be minimal, maximum exposure can be realized.

 

What Does Liquidation Mean?

Occasionally, traders may experience a liquidation of their position. Known as a margin call, the level of margin available to you reflects if you are likely to have open positions forcibly closed should the market move against your favour. For example, in Bitcoin leveraged positions where there is fairly high volatility, the market may suddenly move to the downside by a significant amount while you have a leveraged long open.

In this case, it would be likely if you had opened a position with 100x leverage that you would receive a margin call. Before your position is closed, you will receive a notification to inform you that your position is at risk.

As liquidation events can take place rapidly, it can be shocking for novice traders to see that their position has been closed. But there are steps you can take to minimize your chances of being liquidated. For example, using lower leverage of say 50:1 will result in a higher resilience to liquidation should a sudden market fluctuation occur. Additionally, adding new funds to your open position, and thus increasing your initial margin, will reduce your risk of being liquidated. The higher the leverage, the less you place at risk, but the greater the probability of losing it.

How Does Leverage Trading Differ from Spot Trading?

Spot trading is one of the most familiar forms of trading, which includes purchasing an asset at its current price for delivery on that specified spot date. Unlike a leveraged trade, which fundamentally relies on using borrowed capital, spot trades are usually physically delivered. This means that the underlying asset being traded, for example, Ethereum, must be actually delivered to the trader once the contract expires.

On the other hand, when traders use leverage, they are almost never trading for physical delivery of the underlying asset, because a large portion of their position is borrowed. Instead, they are trading a derivative of that asset, which is a financial product which is based on an agreed-upon underlying asset – in this case, cryptocurrencies. These derivatives still wholly derive their value from the market movements of the underlying digital asset, but without true ownership.

Using Leverage Trading to Your Advantage

Understanding the basics of crypto leverage is the first step towards increasing your repertoire of trading skills. A powerful trading tool when used correctly, leverage trading can significantly increase profits from a modest sum of margin capital, and trading with leverage is also useful for selling short in bear market periods.

It’s worth remembering that trading with leverage can also increase your risk of liquidation or magnify losses if the market moves against you, and traders should take steps to minimize their exposure to these risks as they trade.

Points to be cautious about before you start Leverage Trading

– Excessive Leverage Trading – As mentioned earlier, the higher the leverage taken, the higher are the chances of the trade being liquidated as there isn’t too much room for movement. Studies have shown that trades with 100x leverage lead to higher losses than trades with lower leverage.

Other charges – Leveraged Trading is essentially borrowing money to enter into a particular trade. This money, either from the exchange or the counterparty comes at a cost which sometimes is overlooked by the trader. Ensure you include the other charges in your p/l before accounting for the final figure.

– Beware of Volatility – Cryptocurrencies are considered to be highly volatile assets causing heavy movements on both side. For a trader using leveraged trades, it is important to look closely at the trades entered so as to know the position of the trade.

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