TL;DR
In crypto trading, leverage refers to using borrowed capital to make trades. Leverage trading can amplify your buying or selling power, allowing you to trade larger amounts. So even if your initial capital is small, you can use it as collateral to make leverage trades.
While leverage trading can increase your potential profits, it is also subject to high risk â especially in the volatile crypto market. Be careful when using leverage to trade crypto, as it may lead to substantial losses if the market moves against your position.
Introduction
Leverage trading can be confusing, especially for beginners. This article will focus on leverage trading in crypto markets, though a great portion of the information is also valid for traditional markets.
What Is Leverage in Crypto Trading?
Leverage refers to using borrowed capital to trade financial assets, including cryptocurrencies. 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 â such as 1:5 (5x), 1:10 (10x), or 1:20 (20x) â and shows how many times your initial capital is multiplied. For example, if you have $100 in your exchange account but want to open a position worth $1,000 in bitcoin (BTC), a 10x leverage will give your $100 the same buying power as $1,000.
You can use leverage to trade different crypto derivatives. The common types of leverage trading include margin trading, leveraged tokens, and futures contracts.
How Does Leverage 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 known as collateral. The collateral required depends on the leverage you use 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 10x leverage. The margin required would be 1/10 of $1,000, meaning you must have $100 in your account as collateral for the borrowed funds. If you use 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 risk of liquidation.
Apart from the initial margin deposit, you must also maintain a margin threshold for your trades. If the market moves against your position and the margin falls below the maintenance threshold (also called the maintenance margin), youâll need to put more funds into your account to avoid liquidation.
Opening a long position means you expect the price of an asset to rise. On the other hand, opening a short position means you believe the price will fall.
Leverage allows you to buy or sell assets based only on your collateral, not your holdings. This means that you can borrow assets and sell them (open a short position) even if you don't currently own them. This allows you to potentially profit if the price goes down.
Example of a leveraged long positionÂ
If you want to open a long position of $10,000 worth of BTC with 10x leverage, you will use $1,000 as collateral. If the price of BTC rises 20%, youâll earn a net profit of $2,000 (minus fees), which is much higher than the $200 you would have made if you had traded your $1,000 capital without leverage.
However, if the price of BTC drops 20%, your position would be down $2,000. Since your initial capital (collateral) is only $1,000, a 20% drop would trigger liquidation (your balance drops to zero). In fact, you could face liquidation even if the market only drops 10%. The exact liquidation value depends on the exchange you use.Â
To avoid liquidation, you must add more funds to your wallet to increase your collateral. In most cases, the exchange will send you a margin call before liquidation (e.g., an email telling you to add more funds).
Example of a leveraged short positionÂ
If you want to open a $10,000 short position on BTC with 10x leverage, you must borrow BTC from someone else and sell it at the current market price. Your collateral is $1,000 but since you are trading with 10x leverage, you can sell $10,000 worth of BTC.
Assuming the current BTC price is $40,000, you would have borrowed 0.25 BTC and sold it. If the price drops 20% to $32,000, you can buy back 0.25 BTC for just $8,000. This would give you a net profit of $2,000 (minus fees).Â
However, if the price of BTC rises 20% to $48,000, you would need an extra $2,000 to buy back the 0.25 BTC. In this case, your position will be liquidated as you have only $1,000 in your account balance. Again, to avoid liquidation, you must 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, leverage trading could also lead to significantly greater losses.
Another reason traders 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 rest of their money in another place, such as trading another asset, staking, providing liquidity to decentralized exchanges (DEX), and investing in NFTs.
How to Manage Leverage Trading Risks
Trading with high leverage might require less starting capital but it increases your liquidation risk. The higher the leverage, the smaller your volatility tolerance â if your leverage is too high, even a 1% price movement could lead to huge losses.Â
Using lower leverage, on the other hand, gives you a wider margin of error. This is why many crypto exchanges impose limits on the maximum leverage available to new users.
Risk management strategies like stop-loss and take-profit orders help minimize losses in leverage trading. You can use stop-loss orders to automatically close your position at a specific price, which is useful when the market moves against you. Stop-loss orders can protect you from significant losses, while take-profit orders automatically close when your profits reach a certain value. This allows you to secure your earnings before the market condition turns.
Leverage trading is ââa double-edged sword that can exponentially amplify both your gains and losses. It involves a high level of risk, especially in the volatile cryptocurrency market. As such, Binance encourages users to trade responsibly by taking accountability for their actions.
It also offers tools like an anti-addiction notice and the cooling-off period function to help users exercise control over their trades. Traders should always exercise extreme caution and always remember to DYOR to understand how to use leverage properly and plan their trading strategies.
Closing Thoughts
Leverage allows you to get started on trading with a lower initial investment and the potential for higher profits. Still, leverage combined with market volatility could cause rapid liquidation, especially if youâre using 100x leverage.
Always trade with caution and evaluate the risks before engaging in leverage trading. You should never trade funds you cannot afford to lose, especially when using leverage.
Further Reading
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