What Is Leverage Trading in Crypto? A Beginner's Guide to Risks and Rewards

What is Leverage Trading?

To understand leverage trading, first let's understand what trading means in brief. Trading is the activity of buying and selling financial assets such as crypto with the hope of making a profit.

The capital you use to trade determines how big your profits and losses are. It's simple. The more money you put to trade, the more profit you can make as well as the more risk you take if your trade goes against you and makes you a loss.

Leverage trading means using borrowed funds, in addition to your own capital, from a broker or crypto exchange to increase your trading position. To put it humorously: it's like trading on steroids - it amplifies both your potential profits and losses!

Leverage trading is therefore considered as one of the biggest risks in trading, and you should not try this type of trading unless you are fully prepared to accept the risks involved. 

Note: Leverage trading is not limited to crypto trading, leverage trading is a general term in the trading environment when traders use borrowed funds to trade financial assets like stocks, commodities and currencies. (Forex).

Key Terms You Should Know

Before moving onto the topic of how leverage trading works, there are few key terms that you should be aware of. Don't worry, these terms are not hard. 

Margin

This refers to your own capital that you need to put in order to open a trade or trading position.

Leverage

This represents the borrowed money. Leverage is shown as a ratio to your margin or your own capital. When a crypto exchange such as Binance or Kraken provides you a leverage of 1:10, this means they are willing to give you 10 times more money in addition to your own funds.

So, let's say you have $100 of your own funds, a leverage of 1:10 means you now get $1000 to open a trade or trading position. If the leverage ratio is 1:20, then they are willing to provide you $2000 to open a trade. 

Trading Position

This is the actual size of the trade that you are opening. Your trading position is therefore your margin, and the leverage applied to it. 

The formula for the trading position is:

Trading Position = Margin × Leverage

For example, if your margin is $100 and your leverage is 1:10 (which means 10x leverage), you would calculate your trading position like as below: 

$100 × 10 = $1,000

To find the margin, divide the trading position by the leverage:

Margin = Trading Position ÷ Leverage

Example: $1,000 ÷ 10 = $100 margin.

To find the leverage, divide the trading position by the margin:

Leverage = Trading Position ÷ Margin

Example: $1,000 ÷ $100 = 10 leverage.

Liquidation

Liquidation means losing the initial funds or margin you used to open your trading position. Your broker or exchange will close your position once your losses consume your margin, ensuring that your account does not go into a negative balance.

Going Long and Going Short

Going long or taking a long position means you bet the price of a financial asset will increase from its current market price.

Conversely, going short means or taking a short position means you bet the price of an asset will fall.

How does Leverage Trading Works

Now let's look at how you are going to make and lose money significantly with leverage. 

Imagine you want to trade Bitcoin (BTC) and you believe that its price will go up.

You only have $200 with you. But because you are so sure that bitcoin price will go up, and that you want to enjoy a lot of profit, you used leverage at 1:10, meaning the exchange gave you $2000. 

Let's assume the current price of bitcoin is $50,000. So, you decided to put a long position (this means you bet that the price of bitcoin will go up). 

With leverage, now you have $2000 worth of Bitcoin, this means you have 0.04 BTC ($2,000 ÷ $50,000).

Now let's see what happens if Bitcoin price goes up

If the price of BTC rises by 10%, going from $50,000 to $55,000. The value of your 0.04 BTC increases accordingly:

Your investment with leverage 1:10 = $2000 ($200 x 10 = $2000)

New value of your position = 0.04 × $55,000 = $2,200

Profit = New value of your position - Initial trading position

Your profit = $2,200 - $2,000 = $200

Wow! You just doubled your initial margin of $200 by using leverage with this 10% price increase. So when you close your position, you now have $400 with you in your hand.

But what if  you did not use leverage?, then you would only get a profit of $20, leaving only a total of $220 with you. You do the math here!.

So by using a leverage of 10x, you just multiplied your gains 10 times!, this is nice as long as your trade does not go against you. 

What if the price of Bitcoin goes down against your long position

If Bitcoin's price drops by 10%, from $50,000 to $45,000? Then you will lose all your money! 

This is how you will lose:

Your investment with leverage 1:10 = $2000 

New value of your position when BTC drops = 0.04 × $45,000 = $1,800

Your loss = 1800 - 2000 = - $200

Now, your entire $200 margin is gone. This means you’re liquidated, and the exchange automatically closes your position to prevent further losses. You lose your $200 margin completely.

See, a 10% change is enough to lose all your money, and this happens in seconds! 

*Now remember this very well. The more leverage you use, the greater the potential profit and the greater the risk of loss, even with small percentage changes in the price of the crypto.

Let's say in the above example, you used a leverage of 1:50, meaning you got $10,000 trading power to open a position from your initial capital of $200.

In the above case, At the current Bitcoin price of $50,000, you can buy 0.2 BTC ($10,000 ÷ $50,000).

If Bitcoin Price goes up by 10% from $50,000 to $55,000, then your profit would be:

Your investment with leverage 1:50 = $10,000 

New value of your position = 0.2 × $55,000 = $11,000

Your profit = $11,000 - $10,000 = $1,000

When you close your position, this leaves you with a total of $1200 in your hand which is great!

If Bitcoin’s price goes down by 10%

If Bitcoin’s price drops from $50,000 to $45,000, the value of your 0.2 BTC decreases:

New value of your position = 0.2 × $45,000 = $9,000

Your loss = $9,000 - $10,000 = - $1,000

But don't think that your exchange will wait until you make that loss, they will liquidate your account when your loss reaches $200, this means that when bitcoin drops by 2%, your money is gone! 

Therefore, at 1:50 leverage, even a 2% price drop could liquidate your position, as your margin would no longer cover the losses.

Don't forget that you can put short positions also. 

Let's see an example of a short position

Your initial investment (margin) = $200

Leverage = 1: 10

Position Size = $200 × 10 = $2,000

Current Bitcoin price level = $50,000

Your bitcoin holding is 2000 ÷ 50,000 = 0.04

Scenario: Price of Bitcoin increased by 10% against your short position of $2000

New BTC Price = $50,000 × 1.10 = $55,000 

New value of your 0.04 BTC = 0.04 × $55,000 = $2,200

Loss = Initial position size - new position value

Loss = $2,000 - $2,200 = - $200

You incurred a loss of $200 and your whole investment got wiped out because you bet the price would go down. When the price moves against your prediction, you incur a loss for every penny it moves in the opposite direction.

In case if the price of bitcoin falls by 10% in your short position, then you would gain a profit of $200. Provided that your initial investment is $200, and leverage is 1:10. You do the math here!

The Risks of Crypto Leverage Trading

Liquidation Risk

Since the cryptocurrency market is highly volatile, the liquidation risk in this market is very real when compared to any other market such as forex and stocks.

The higher your leverage, the greater you carry your risk of getting liquidated. 

The relationship between leverage and the risk of liquidation can be expressed as follows:

Liquidation Price Distance (%) = 100% ÷ Leverage

Leverage 1:5 (5x):

Liquidation Price Distance = 100% ÷ 5 = 20%

A 20% unfavorable price movement leads to liquidation.

Leverage 1:10 (10x)

Liquidation Price Distance = 100% ÷ 10 = 10%

A 10% unfavorable price movement leads to liquidation.

Leverage 1:50 (50x)

100% ÷ 50 = 2%

A 2% unfavorable price movement leads to liquidation.

Leverage 1:100 (100x)

100% ÷ 100 = 1%

A 1% unfavorable price movement leads to liquidation.

New and Inexperienced Traders are at most Risk

According to statistics, new traders are most at risk of getting REKT from using leverage in futures trading or other types of trading that allows leverage. 

So if you are new to trading, i do not recommend to try leverage trading because this type of trading is extremely risky,  instead you can start with spot trading in crypto, do it for couple of years, build up your trading discipline, understand the market dynamics very well and then you can try leverage using healthy or low leverage such as 1:5. 

I personally know people who tried futures trading where leverage is available just out of their greed and lost thousands of dollars and ended up hating trading. So it's best to take the long road to achieve success when it comes to trading, short cuts are traps!

Everyone wants you to do Leverage Trading

People are driven by fear and greed, and many people are too greedy and always look for shortcuts to earn money.

This is the main reason why leverage trading is very much popular in crypto compared to spot trading. In spot trading you do not use leverage, and the crypto you buy belongs to you, you can hold the coins and decide not to sell even if the value of the coins falls below your purchase price.

As long as you hold your cryptocurrency, you can sell it anytime when the market recovers and prices rise. Spot trading is extremely safe compared to leverage trading. 

But it is that leverage trading everyone encourages you to try. For example, YouTubers focus on leverage trading, often promoting it heavily. They even sell overpriced courses and make exaggerated claims. 

Their thumbnails are hilarious and filled with clickbait titles like, “How I made $100,000 in a day with this secret trading strategy”, “The trading strategy that nobody wants you to know”, and if you watch those videos, they are trading futures using leverage and it's all clickbait. 

What about exchanges? Have you noticed how many exchanges make futures trading look exciting by visually showing your profits and losses in real time? These visually appealing profit calculators are designed to lure you into risky trading.

Moreover, anyone can share their profits with others in futures trading attaching referral codes. Referral codes encourage others to sign up and start trading in exchanges. When profits are shown nicely in green color with big letters, it creates a sense of urgency and excitement, pushing people to jump in quickly. 

Exchanges love trading volume, the higher the trading volume occurring, the higher they can charge you with transaction fees. So, they use every kind of marketing gimmick to play with your emotions. Don't fall for it.

Final Thoughts

Leverage trading is a double-edged sword. If you use it wisely, it can generate immense wealth, but if used foolishly, it can ruin your life. It’s best to use leverage trading only if you are an experienced spot trader who has achieved consistency in making profits over the long term.

Remember, trading requires a lot of discipline, and it’s a process. If you start trading with your focus solely on the results, you are likely to fail. Instead, you should focus on the process - the process of achieving discipline, self-control, and consistency in making profits.

Don’t fall for the bait of earning quick money in trading. While it’s true that you can use stop losses, sell targets and money management to protect your capital when using leverage trading, the reality is that many people are driven by emotions and therefore fail to implement these measures. 

This is a fact that you can’t ignore. Don't believe me? try leverage trading after taking a course and see how challenging it is to control your emotions and stick to your plan.

With all the setbacks, losses, broken rules, obstacles, and challenges, it takes time to become emotionally mature. Let that sink in deeply. 

 

Disclaimer: The contents of this article are for informational purposes only and are not financial advice. The views here are just the author’s opinions. The crypto market is volatile, so be sure to do your own research before investing.