If you’ve had some experience with trading Forex or stocks, you’ve probably come across the idea of leverage, which allows you to open a larger trade than the value you are holding on your account. But is it worth using this tool when trading or investing in crypto?
In this article, I’ll outline what leverage is, the risks and benefits of using it in your crypto trading, and what to keep in mind when using leverage on crypto.
What is leverage?
Leverage is a tool allowing an investor to open a larger trade than his available money could permit him to do outright.
The most well-known form of leverage is in real estate. When a person is willing to purchase a house, often it will be done through a down payment. The rest of the value of the house will be topped up by the bank. However, the buyer receives ownership of the asset and is free to live in it fully (Mr. Bankman can’t start living in 80% of your house).
The same concept is available in investing. You may leverage your positions; it means that someone will be topping up your position with their money for the duration of the trade.
The money that you have invested (down payment) is called the “margin”. And the “leverage” is the amount the lender has provided. When leveraging, the result of your trade belongs to you. This means that if you have made a massive profit, you will be getting the entirety of it, the downside being if you do not.
For example, if you decided to buy a house worth $1,000 but only had $200 in your bank account, you would negotiate with a bank for a loan. The bank would then require you to provide $200 as a down payment or collateral for the loan to take ownership of the house. If you decided to sell the house ten years later for $1,500, you would have made a profit of $500.
The leverage ratio is the method used to assess risk and better understand the situation. As the cost to buy the house was $200, and the full price for the house was $1,000, the leverage ratio is (1:5). This is due to the fact that the total value is five times higher than the invested value. On the left is the margin (1), and on the right, the total value (5).
You may also encounter the following format: “Margin = 20%”. This means that your stake in the position is 20% of the total position’s value; you are therefore leveraging at a rate of, yet again (1:5).
It is worth noting that for most margin services on the market, your trade will be cancelled for you if the result goes below your capital investment. This is not always the case, however, which is why it is very important, before using it, to understand how leverage works.
How does leverage on crypto work?
Using margin in the cryptocurrency sector is quite similar to using it in the traditional market. The main difference is that you have to account for the stronger up and downtrends.
Imagine opening a long Bitcoin trade at $56,500 (see the red circle in the chart). Then, you invest a margin of $500 with a leverage ratio of (1:10), making the total value of your position $5,000.
At first, your trade goes favourably - the price of Bitcoin rises to $58,760, or by 4% (you can see the price hit the green line on the chart). This means that your trade is also making 4% of $5,000, or $200. You are hesitating, as $200 represents 40% of your initial investment of $500, so it’s a big win.
By contrast, if you had invested the full $5,000, such as by buying the asset outright, your return would still be $200, but that would only be a return of 4% when compared to your initial investment. This is where the real power of leverage is evident, as your returns compared to your initial investment are magnified. The same is true of your losses, however.
You decide to keep the investment going to try to achieve a bigger return, but you notice Bitcoin’s price starts going down. Thirty-six hours after your trade, instead of having a 4% profit, you have a 4% loss as BTC’s price drops to $54,240. This, therefore, represents a loss of $200, which is also 40% of your initial investment.
If we compare this to an outright investment of $5,000, the $200 loss would be a loss of “just” 4%.
What are the risks of trading with leverage?
As seen, leverage can be a very powerful tool to amplify the size of your profits. But this also means that it might amplify the losses.
Cryptocurrency is an extremely volatile market, and using magnifiers on the rates that we see daily is massively risky if the trader does not precisely know what he is doing.
In the preceding examples, it was mentioned that some companies would sell your position if it were to drop too much. This is called an “automatic stop-loss”, and once it’s activated, your position is no more, regardless of the following swings.
In addition to that, the leverage provider may charge an “overnight fee”, which is a certain percentage of the total value of your asset, charged for every night you keep your trade open. This is not an issue for trades of less than a day, but for someone interested in holding leveraged positions in the long term, this could have an extreme impact on profits if not properly factored in.
What are the benefits?
When a resourceful trader gets his hands on leverage and measures his ratios correctly, there is a large potential upside. This can provide profits that would have required much more time and effort to obtain without using margin. This and financially help skilful investors grow their portfolios exponentially and make the most out of their time.
Going back to the example used before, the 4% increase in the price of the asset provided a profit of $200, which was 40% of the invested capital. Achieving a 40% profit takes time (often years), research and risk. A 4% increase, though, is not uncommon on the cryptocurrency market, so this scenario is realisable.
Depending on the regulations in your area, the downside may only be the amount invested. However, it is best to check where any broker or platform you use is regulated. There are still some jurisdictions where traders using leverage could end up holding a negative balance and have to pay back that debt to the broker or platform.
What crypto investors should consider before trading with leverage
Here is a small list of areas to pay very close attention to while leveraging your positions for the simple reason that you don’t want to risk placing a magnifier on a trade you are uncertain of.
1. How much research did you do, and how good are you with graphs?
How well do you know the strengths and risks of your investments? For example, have you conducted a SWOT analysis (which measures Strengths, Weaknesses, Opportunities and Threats) or used any other tools to assess the risk/profit ratio?
How certain are you that your position will be profitable?
Is the daily news going to affect your holding, and if yes, why?
You have to understand getting the price moving on the market that your asset is being traded in.
As we discussed, the incentive to keep your trade for the long run is not as big while leveraging. Mainly because of the potential massive intraday price swings, but also the overnight fee. You, therefore, have to assess how well your currency will be doing in the upcoming hours or days. Again, this related to understanding the market, the graphs, and reading the daily news.
2. What leverage ratio to use? How much of a drop could your asset see?
Correctly setting your leverage rate is vital to ensuring the best risk/return ratio. For example, if you know it’s normal for a certain coin to move 5% for no other reason than supply and demand, you might want to take that into account while choosing your rate.
I will demonstrate this by changing the leverage ratio on the BTC example seen before. In the example, BTC’s price when the trade was opened was $56,500. The price rose by 4% to $58,760, only to later drop to 4% below the opening price, to $54,240. With a leverage ratio of (1:10), that would represent a profit or loss of $200, depending on when you exited the trade.
If we set the leverage ratio to (1:50), the value of the position would be $25,000, rather than $5,000, with a 4% profit or loss being worth $1,000 - twice the trader’s margin. The 4% volatility could have knocked the trader out of the water in minutes. If the provider did not close the position, the investor would make a 200% loss! However, in most cases, the position would have been automatically closed as soon as the price of BTC lowered by 2.5%.
In conclusion
Leverage is a result multiplier, which means that it is very advisable to be a trained trader before using this particular tool. Experience is an extremely valuable asset and is in my opinion necessary in that particular case. Calculate how much the asset is likely to move, up and down, and calculate the leverage ratio you would rather use based on this information and everything you will have had collecting before that.
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