Key Takeaways:
- Leverage refers to using borrowed capital to open a trading position, which can amplify the potential gains or losses.
- The main leverage methods available in crypto are margin trading, futures, and options contracts.
- There are several risks associated with crypto leverage trading, including volatility, liquidation, interest costs, and counterparty risk.
- Risk management is paramount, and responsible leverage used smartly can be an effective tool to enhance trading returns.
What Does Leverage Mean?
Leverage refers to using borrowed capital to open a trading position, which can amplify the potential gains or losses. When leverage is applied, a trader can control a larger position in an asset than they could if they were only using their own capital. This magnification of returns also magnifies the risks, as losses are also amplified.
Leverage isn’t unique to cryptocurrency; it’s also used in traditional financial (TradFi) markets like stocks, bonds, commodities, and real estate.
How Does Leverage Trading Work in the Crypto Market?
Imagine having $1,000 but using leverage to control a $10,000 position in a crypto trade, which would amplify gains if the trade moves favourably. For example, if the crypto asset appreciates 1%, profit isn’t based on the $1,000 capital; rather, it is based on the $10,000 leveraged position.
However, leverage trading in crypto can also intensify losses. If the trade goes against expectations, losses are calculated on the leveraged amount ($10,000 in the example above), not just the initial capital.
Example of Crypto Leverage Trading: BTC Trade
Let’s say you have $1,000 and use 10 times (10x) leverage to open a BTC trade. With leverage, you control a position worth $10,000 (10x investment), but remember that leverage amplifies both profits and losses: While it can maximise gains, it increases risk. In this example, a 1% BTC price move results in a 10% gain or loss due to 10x leverage.
Initial Capital: $1,000
Leverage: 10x (controlling $10,000 position)
BTC Price: $60,000 per coin
Profit Scenario:
If BTC rises 1% to $60,600, profit is $100 (1% x $10,000), meaning a 10% gain on initial capital of $1,000.
Loss Scenario:
If BTC drops 1% to $59,400, loss is $100 (1% of $10,000), meaning a 10% loss on initial capital of $1,000.
Different Types of Leverage Trading
There are a few main ways that leverage trading has been incorporated into crypto markets. Below is a brief overview of how each one works:
Contracts for Differences (CFDs)
Contracts for Differences (CFDs) are a financial instrument allowing traders to take a market view on the price movements of cryptocurrencies without actually owning the underlying asset. They are an agreement between the trader and a broker to exchange the difference in the value of a cryptocurrency from when the trader opens the position to when they close it, allowing traders to take a speculative position. Traders simply buy and sell CFDs as they would the underlying asset.
Read more about CFDs here.
Margin Trading
Margin trading allows crypto traders to borrow funds from their cryptocurrency exchange to open leveraged spot positions. Traders deposit collateral capital as a margin and can then open positions valued at a multiple of that margin amount. Note that exchanges set margin requirements and maintenance margin levels that may trigger forced liquidations if not maintained. Profits or losses are realised when positions are closed out.
Read more about crypto spot and margin trading here.
Crypto Futures
Crypto futures contracts allow traders to take long or short positions on cryptocurrencies without having to own the underlying asset. Similar to the above, traders deposit collateral capital as a margin and can then open positions valued at a multiple of that margin amount, therefore achieving leverage. Daily price fluctuations result in profits or losses being settled to accounts each day through a process called ‘marking to market’. As above, forced liquidations are also a risk when trading futures.
Read more about crypto futures here.
Crypto Options
Options contracts give the buyer the right, but not the obligation, to buy or sell the underlying crypto asset at a set ‘strike’ price on or before the expiration date. The seller/writer takes on the obligation to fulfil an option if the buyer exercises the option. Leverage is achieved due to the relatively small upfront premium paid compared to the size of the position opened.
Read more about crypto options here.
Is Leverage Trading Safe?
As described, while leverage allows traders to magnify potential profits, it also magnifies potential losses. There are also other risks:
- Volatility: Crypto markets are notorious for high volatility, with frequent double-digit price swings not uncommon, which makes them particularly risky for leverage trading if the price moves unfavourably.
- Liquidation: In leveraged trading, the borrowed funds act as collateral. If the market moves unfavourably, failure to meet margin calls could mean the position is liquidated by the exchange to cover losses.
Learn more about margin calls and liquidation here.
- Interest Costs: Margin trading often involves paying interest on the borrowed funds. This can impact the overall profitability of leveraged positions.
- Counterparty Risk: Engaging with leveraged positions through exchanges or borrowing platforms exposes traders to counterparty risk. Dependence on these platforms for leveraging funds can subject traders to potential platform failures, hacks, or insolvencies, leading to loss of funds.
Given these risks, it is crucial for traders to conduct research and practise prudent risk management techniques like strict position sizing, stop losses, and diversification. Nevertheless, responsible leverage used smartly can be an effective tool to enhance trading returns.
Read more about what influences crypto prices here.
Conclusion
Leverage trading allows cryptocurrency traders to open larger positions using borrowed capital. It gives opportunities for enhanced profit potential but also increases downside risks. The main leverage methods available in crypto are margin trading, futures, and options contracts.
Risk management is paramount given leverage’s ability to amplify both wins and losses, particularly as crypto markets are highly volatile. When handled carefully, leverage can be an effective tool.
Due Diligence and Do Your Own Research
All examples listed in this article are for informational purposes only. You should not construe any such information or other material as legal, tax, investment, financial, cybersecurity, or other advice. Nothing contained herein shall constitute a solicitation, recommendation, endorsement, or offer by Crypto.com to invest, buy, or sell any coins, tokens, or other crypto assets. Returns on the buying and selling of crypto assets may be subject to tax, including capital gains tax, in your jurisdiction. Any descriptions of Crypto.com products or features are merely for illustrative purposes and do not constitute an endorsement, invitation, or solicitation.
Past performance is not a guarantee or predictor of future performance. The value of crypto assets can increase or decrease, and you could lose all or a substantial amount of your purchase price. When assessing a crypto asset, it’s essential for you to do your research and due diligence to make the best possible judgement, as any purchases shall be your sole responsibility.
