To rookie investors in crypto, the question: what is leverage trading crypto, may frequently be on their minds. As a start, we need to understand that leverage trading in crypto is a tool that enables investors to maximise profits through the borrowing of money from brokers. However, this action comes with a relatively high risk, as investors can potentially lose unprecedented amounts of money.
How does it work?
Now, what is leverage trading crypto exactly?
With a margin trading account, investors can essentially put in a percentage of the total order value. As aforementioned, investors borrow capital to trade cryptocurrencies and other assets. Investors can borrow up to 100 times their account balance (however, this is highly not encouraged).
Usually, leverage is referred to as a ratio, such as 1:5 (5x), 1:10 (10x) etc. This means that investors are using less assets to open larger positions than they are initially not capable of. For example, when there is a 10x leverage, investors can use $100 in their trading account to open a position worth $1,000 in Bitcoin. In this case, the initial capital of $100 is known as the collateral or the initial margin deposit.
Investors would have to maintain a margin threshold. When the market fluctuates against your position, causing you to lose money and leading to the margin being lower than the threshold, you would be required to add more funds into the account to meet the threshold. If you fail to do so, the initial collateral that you have placed in the account will be liquidated by the brokerage.
This is the beauty (and the downside) of leverage trading crypto. Investors are essentially betting that the market will move in their favour, causing them to earn profits. Let us take a look at the two types of leverage trading: long leverage trading and short leverage trading.
Long Leverage Trading
Let’s say that you want to open a long position of $10,000 worth of BTC with 10x leverage. You will therefore use $1,000 as collateral. Should the price of BTC go up by 20%, there will be a net profit earned of $2,000. This is much higher than the $200 that you would have made originally if you traded your $1,000 capital without leverage.
On the other hand, a BTC price drop of 20% would cause your position to be down $2,000. Since the initial collateral was $1,000, this drop would cause your funds to be liquidated. Thus, to avoid such a situation, you would have to add more funds to the wallet to increase the collateral. Typically, the exchange would notify you to add more funds (a.k.a margin call).
Short Leverage Trading
Let’s say you want to open a $10,000 short position on BTC with 10x leverage. This means that you would have to borrow BTC from someone else and sell it at the current market price. Following which, you would have to buy the same amount of BTC back. In this case, should you place $1,000 worth of collateral, you can sell $10,000 worth of BTC.
Imagine the price of BTC currently is $40,000, you borrowed 0.25 BTC and sold it. If the BTC price drops 20% (down to $32,000), you can buy back 0.25 BTC with just $8,000, giving you a net profit of $2,000.
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. Your position would be liquidated due to your account balance only having $1,000. More funds need to be added to the wallet to avoid liquidation.
Benefits and risks
Leverage trading can maximise profits and amplify losses. Traders may also use leverage to improve 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 other portion of their money in another place.
It is important that investors manage risks in leverage trading. An abnormally high leverage will lead to huge losses even if the price movement is small. New traders should use lower leverage rates to reduce the possibility of huge losses.
Risk management strategies like stop-loss and take-profit orders help minimize losses in leveraged trading. Stop-loss orders automatically close your position at a specific price, which is very helpful when the market moves against you. Take-profit orders are the opposite; they automatically close when your profits reach a certain value. This enables you to secure your earnings before the market condition changes for the worse.
In Conclusion
What is leverage trading crypto? We hope that this article answers your questions and provides you with greater insight on how to properly utilise leverage trading to earn profits. Even though this field is very risky, with proper caution and preparation beforehand, users can definitely maximise profits while greatly reducing losses.
