What is leverage in cryptocurrency trading?

In cryptocurrency trading, leverage refers to using borrowed funds to trade. Leveraged trading can expand your ability to buy or sell, allowing you to trade larger amounts. Therefore, even if your initial capital is small, you can stake it for leveraged trading. While leveraged trading can multiply your potential profits, there are also high risks, especially in the volatile cryptocurrency market. Exercise caution when trading cryptocurrencies with leverage. If the market moves against your position, you may suffer serious losses.

Leveraged trading can be very difficult to understand, especially for beginners. But before trying to use leverage, it is important to understand what leverage is and how it works. This article will focus on leveraged trading in the cryptocurrency market, but most of the information in it applies to traditional markets as well.

What is leverage in cryptocurrency trading?

Leverage refers to the use of borrowed funds to trade cryptocurrencies or other financial assets. It can expand your ability to buy or sell, allowing you to have more tradable funds than you currently have in your wallet. Depending on the cryptocurrency trading platform you trade on, you can borrow up to 100 times your account balance.

Leverage is expressed in ratios such as 1:5 (5 times), 1:10 (10 times) or 1:20 (20 times). The scale shows the magnification of the initial funds. For example, let's say you have $100 in your TWS account but want to open a Bitcoin (BTC) position worth $1,000. With 10x leverage, your $100 in purchasing power would be equivalent to $1,000.

You can trade different cryptocurrency derivatives with leverage. Common types of leveraged trades include margin trading, leveraged tokens, and futures contracts.

How does leveraged trading work?

You need to deposit funds into your trading account before you can borrow funds to start trading with leverage. The initial capital you provide is what we call collateral. The required collateral depends on the leverage you use and the total value of the position you want to open (called margin).

Say you want to invest $1,000 in Ethereum (ETH) with 10x leverage. The required margin is 1/10 of $1,000, which means you need to have $100 in your account as collateral for borrowed funds. If you use 20x leverage, the required margin will be lower (1/20 of $1,000 = $50). But keep in mind that the higher the leverage, the higher the risk of being liquidated.

In addition to the initial margin deposit, you also need to maintain a margin threshold for your trades. When the market moves against your position and the margin falls below the maintenance threshold, you need to put more money into your account to avoid being liquidated. This threshold is also known as the maintenance margin.

Leverage can be applied to both long and short positions. Taking a long position means that you expect the price of the asset to rise. Conversely, taking a short position means that you expect the price of the asset to fall. While this may sound like a regular spot trade, using leverage allows you to buy and sell assets only on the basis of collateral rather than funds held. So if you think the market will go lower, you can borrow the asset and sell it (open a short position) even if you don't have it.

Example of a Leveraged Long Position

Suppose you want to open a long BTC position worth $10,000 with 10x leverage. This means you need to use $1,000 as collateral. If the price of BTC rises by 20%, you will earn a net profit of $2,000 (minus fees), which is much higher than the $200 you would get by trading $1,000 without leverage.

But if the price of BTC drops by 20%, your position will drop by $2,000. Since your initial capital (collateral) is only $1,000, a 20% drop will result in a liquidation (your balance will go to zero). In fact, even if the market only drops by 10%, you may be forced to liquidate your position. The exact liquidation value depends on the trading platform you use.

To avoid forced liquidation, you need to transfer more funds to your wallet and increase your collateral. In most cases, the trading platform will send you a margin call (such as sending an email to remind you to add more funds) prior to a liquidation.

Example of a Leveraged Short Position

Now suppose you want to open a $10,000 short BTC position with 10x leverage. In this case you need to borrow BTC from others and sell it at the current market price. Your collateral is $1,000, but you are using 10x leverage, so you can sell $10,000 worth of BTC.

Suppose the current BTC price is $40,000 and you borrow 0.25 BTC and sell it. If the BTC price drops 20% (to $32,000), you can buy back 0.25 BTC for $8,000. This gives you a net profit of $2,000 (minus fees).

But if the BTC price rises by 20% to $48,000, you will need to pay an additional $2,000 to buy back 0.25 BTC. But your account balance is only $1,000, so the position will be liquidated. Again, in order to avoid being liquidated, you need to transfer more funds to your wallet and increase your collateral before reaching the liquidation price.

Why use leverage to trade cryptocurrencies?

As mentioned earlier, traders can use leverage to increase position size and potential profits. But the example above shows that leveraged trading can also lead to higher losses.

Another reason why traders use leverage is that it increases the liquidity of funds. For example, a trader can use 4x leverage to maintain the same position size with lower collateral than holding a 2x leveraged position on a single trading platform. This allows them to use the other part of their funds elsewhere (such as trading another asset, staking equity, injecting liquidity into a decentralized exchange (DEX), investing in NFTs, etc.).

How to manage risk with leveraged trading?

High-leverage trades may require less capital at first, but increase the chances of liquidation. If your leverage is too high, even a 1% price movement can lead to huge losses. The higher the leverage, the lower your volatility tolerance. The lower the leverage used, the more fault-tolerant the trade is. This is why Binance and other cryptocurrency exchanges limit the maximum leverage available to new users.

Risk management strategies such as stop-loss and take-profit orders help minimize losses in leveraged trading. You can automatically close a position at a specific price with a stop-loss order, which is useful when market volatility is against you. A stop-loss order can prevent you from taking significant losses. A take profit order is the opposite; a take profit order automatically closes your position when your profit reaches a certain value. This ensures that you get your money before the market situation changes.

By now, you should know that leveraged trading is a double-edged sword that can multiply your gains and losses. It involves high risk, especially in the volatile cryptocurrency market. Binance recommends that you be responsible for your actions and trade rationally. We provide tools such as anti-addiction notifications and cooling-off features to help you take control of your transactions. You should always be cautious and don't forget to do your own research (DYOR) on how to properly use leverage and plan your trading strategy.

Summarize

Leverage allows you to get started easily with a lower initial investment and potentially higher profits. But leverage is tied to market volatility and can cause liquidations to occur quickly, especially when trading with 100x leverage. Therefore, always trade cautiously and assess the risk before engaging in leveraged trading. Never trade money beyond your personal risk tolerance, especially when using leverage.