Leverage is akin to finding a solid foothold for investors in the realm of cryptocurrency trading. Think of it as a tool that enables you to lift heavy loads, as long as the foundation is steady.
Consider home mortgages as an illustration: Imagine a $1 million house, where the buyer puts down $100,000 and borrows $900,000 from the bank, incurring interest on the loan.
Similarly, businesses with limited funds might opt to utilize borrowed funds for production to amplify their profits. However, this strategy also heightens the risks. If the business doesn't perform as expected, it could find itself in a situation where debts surpass assets.
In essence, leverage involves using borrowed funds to magnify your buying or selling power, enabling you to take on larger trading positions.
What is Leverage?
As previously mentioned, leveraging in cryptocurrency trading involves utilizing borrowed funds to enhance your buying or selling potential. This enables traders to initiate more substantial trading positions than the capital they currently possess. Depending on the trading platform, traders can access leverage exceeding 100 times their account balance.
Moreover, leveraging empowers traders to engage in asset buying or selling even without holding the leverage itself. By utilizing the collateral they've deposited, they can open long or short positions for the cryptocurrency.
Traders commonly employ leverage to secure larger profits. However, it's crucial to acknowledge that higher leverage comes with an increased risk of liquidation. Further insight into this aspect will be provided in the subsequent sections of this article.
Before embarking on leverage utilization, a trader must first fund their trading account. This initial deposit, referred to as collateral, forms the foundation of the trading endeavor. The required collateral, or margin, varies based on factors such as the chosen leverage, desired position value, and the specific cryptocurrency involved.
Leverage is frequently presented as a ratio, providing insight into the extent of position amplification. A 1:10 leverage ratio signifies that the trader multiplies their position size by ten. Let's delve into an example to elucidate this concept further.
Imagine a trader aiming to invest $1,000 in ETHUSDT with 10x leverage. In this scenario, the required margin would be 1/10 of $1,000, equating to $100. Therefore, by depositing $100, the trader can initiate a $1,000 Ethereum position. Alternatively, if the trader opts for 20x leverage, the necessary margin diminishes further, calculated as 1/20 of $1,000, or $50. Nevertheless, it's crucial to recognize that elevated leverage levels entail an augmented risk of liquidation. This outcome arises when the exchange assumes control over the collateral within the trader's trading account.
Traders incur interest charges on borrowed funds and potential losses stemming from leveraged positions. Consequently, exercising prudence when selecting leverage levels is imperative, as excessive leverage can lead to substantial interest payments that might offset trade profits.
After the initial margin is deposited, traders are mandated to uphold a margin threshold. If market fluctuations significantly diverge from the trader's position, the margin could drop below the maintenance margin level. This situation, known as maintenance margin violation, elevates the risk of liquidation. In such circumstances, the trader must inject additional funds to restore the margin threshold, safeguarding against liquidation.
Advantages of Leverage
Utilizing leverage offers several benefits in cryptocurrency trading, enhancing your exposure to digital assets. If you possess a strong conviction about the future direction of a cryptocurrency, you can open substantial long or short positions without committing an extensive amount of capital. This strategy becomes particularly advantageous when your market prediction proves accurate, leading to substantial profit potential.
Leverage also empowers traders to allocate their limited capital more efficiently within the cryptocurrency landscape. By employing leverage, traders can diversify into other crypto market aspects like staking and liquidity provision, thereby generating yields on their invested capital.
Furthermore, leverage provides a practical solution for those lacking sufficient funds to invest in traditional markets. Imagine a scenario where acquiring $50,000 worth of equity is required, yet you possess only $100. Here's where leverage comes into play.
Consider a situation involving Stock A with a minimum lot size of $500 and your available capital of $100. By leveraging your position, you can amplify your trading capability:
At 5x leverage: $100 × 5 = $500. This allows you to acquire $500 worth of stock with a $100 investment.
At 10x leverage: $100 × 10 = $1,000. This enables you to purchase $1,000 worth of stock with the same $100 capital.
You might realize that higher leverage enables you to achieve the same share quantity with less capital, as demonstrated in Scenario 2. However, the use of higher leverage brings along trade-offs, such as potential liquidation risk in volatile markets.
Additionally, trading fees and interest in derivative contracts are often tied to the notional amount traded. In either scenario, the notional amount remains $1,000, leading to similar fee and interest payments. Opting for higher leverage could potentially reduce the margin requirement, but it also heightens the likelihood of accelerated liquidation if market conditions go against your prediction.
It's important to note that without leverage, your exposure to market risk is limited to your initial investment. In contrast, leveraged positions carry the risk of margin calls or liquidation when the position margin approaches the maintenance threshold. To mitigate liquidation risk, traders can opt for lower leverage, which requires a higher margin but provides a larger buffer against sudden market fluctuations.
Drawbacks of Leverage
As previously highlighted, utilizing leverage carries inherent risks.
Leverage is not advisable for beginners entering the cryptocurrency market or long-term investors seeking to hold digital assets. Passive investors should also exercise caution, as leverage demands constant monitoring of margin thresholds to avert liquidation.
The volatile nature of cryptocurrency markets poses a significant danger. If the market veers in the opposite direction of your position, especially when higher leverage is employed, your trading account may face liquidation. Even minor market movements can lead to total account depletion.
When an account nears liquidation, traders typically receive a margin call, signaling low collateral levels. In response, additional collateral can be injected to prevent liquidation.
Implementing risk management strategies is essential to counter these leverage-associated downsides.
Before entering a trade, assess your risk/reward ratio to gauge the necessary margin for desired profits. Set stop-loss and take-profit levels for your positions. A stop-loss automatically closes the trade at a predetermined level to limit losses and avert liquidation. Conversely, a take-profit allows for profit-taking and position closure, safeguarding against potential market reversals and loss of gains.
Leverage is akin to a double-edged sword: it amplifies both investment potential and risk. Successful outcomes hinge on market movements aligning with predictions, but the opposite is also plausible.
Furthermore, leverage elevates cryptocurrency market volatility. Liquidations of a substantial number of traders trigger asset removal from the markets, inducing significant price fluctuations.
Prioritize risk management by implementing protective measures such as stop-losses and take-profits. Safeguarding your account from liquidation remains paramount.