Key Takeaways
Leverage trading is the act of using borrowed capital to make larger trades. It can amplify your buying or selling power, allowing you to trade with more capital than what you have in your wallet.
Leverage trading is often done through margin trading, futures contracts, and options contracts. In the cryptocurrency space, futures and margin are the most common options.
Leverage trading is a popular but risky trading strategy. While it can boost your profits, it can also amplify your losses, especially during periods of high volatility. Make sure you understand how leverage trading works before taking risks.
What Is Leverage Trading?
Leverage trading is using a smaller amount of initial capital to gain exposure to larger positions. It involves using borrowed funds to trade financial assets, such as cryptocurrencies, indices, commodities, and currencies (forex).
In other words, leverage trading amplifies your buying or selling power so you can trade with more capital than what you currently have in your wallet. Depending on the exchange you trade on, you could borrow up to 100 times your account balance.
Typically, the amount of leverage is described as a ratio â such as 1:5 (5x), 1:10 (10x), or 1:20 (20x). The leverage ratio 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.
How Does Leverage Trading Work?
In the crypto space, perpetual futures and margin trading are the most popular methods for trading with leverage.
The concept of leverage trading works similarly with both methods. The main difference is that margin involves borrowing funds from an exchange to trade an asset of your choice, while futures leverage is based on the relationship between the long and short positions of each contract (trading pair).
Initial margin
Before you can borrow funds and start trading with leverage, you need to deposit funds into your trading account, which will act as collateral. The amount required to open a futures contract position is known as the initial margin. The actual value depends on the leverage you use and the size of the position you want to open.
Say you want to invest $1,000 in ether (ETH) with 10x leverage. The initial 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 $50 instead (1/20 of $1,000). But keep in mind that the higher the leverage, the higher the risk of liquidation.
Maintenance margin
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 margin threshold, youâll need to put more funds into your account to avoid liquidation.
In summary, the initial margin is the required balance to open a futures position, and the maintenance margin is the minimum margin balance required to keep your positions open.
On the Binance Futures interface, you can check your Margin Ratio details at the bottom right side of your screen.
Examples of Leverage Trading
If you are new to leverage trading, note that opening a long position means you expect the price of an asset to rise, while opening a short position means you believe the price will fall.
Leverage trading allows you to buy or sell assets based only on the value of your collateral (not your actual holdings). This means that you can open a short position even if you don't currently own the underlying asset and 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 margin is only $1,000, a 20% drop would trigger liquidation (your balance drops to zero). In fact, you could be at risk of liquidation even if the market only dropped 10%. The exact liquidation value depends on the exchange you use.
To avoid liquidation, you must add more funds to your wallet to increase your collateral. You need to ensure your maintenance balance is higher than your maintenance margin. In most cases, the exchange will send you a margin call before liquidation, but itâs important to keep an eye on your open positions. Using stop-loss orders can also help protect your funds.
Example of a leveraged short positionÂ
If you want to open a $10,000 short position on BTC with 10x leverage, you can either borrow BTC to sell (margin trading) or sell $10,000 worth of futures contracts (futures trading). In both cases, you will use a $1,000 collateral (10x leverage), but letâs focus on the margin trading scenario.
Assuming the current BTC price is $40,000, you would have borrowed 0.25 BTC and sold it for $10,000. If the price drops 20% to $32,000, you can buy back 0.25 BTC for just $8,000. Then, you can repay your 0.25 BTC debt and keep the $2,000 (minus fees) difference as your profit.
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 DeFi platforms, and so on.
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.
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 and lock profits 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. Take-profit orders can ensure that your position is closed when your profits reach a certain value.
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 markets. As such, Binance encourages users to trade responsibly by taking accountability for their actions.
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. Make sure you understand the products well before taking risks.
Further Reading
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