A%20beginner’s%20guide%20to%20crypto%20leverage%20trading%20?
Leverage%20trading%20allows%20you%20to%20open%20a%20larger%20position%20than%20you%20otherwise%20would%20be%20able%20to%20with%20the%20funds%20you%20have%20at%20your%20disposal.
In%20the%20simplest%20terms,%20leverage%20amplifies%20the%20value%20of%20your%20available%20capital%20by%20a%20predetermined%20factor,%20which%20in%20turn%20amplifies%20any%20subsequent%20gains%20and%20losses.%20Traders%20often%20use%20leverage%20to%20trade Bitcoin%20(BTC), Ethereum%20(ETH) and%20other%20digital%20assets.
For%20example,%20a%20trader%20might%20leverage%20$100%20of Tether%20(USDT) ten%20times%20(10x),%20to%20open%20a%20$1,000%20position,%20meaning%20that%20any%20profits%20or%20losses%20are%20similarly%20multiplied%20by%2010%20until%20the%20position%20is%20closed.
While%20leverage%20can%20result%20in%20significant%20losses,%20it%20can%20also%20be%20a%20valuable%20tool%20for%20managing%20risk%20effectively%20when%20applied%20with%20careful%20planning%20and%20discipline.
Leverage%20trading%20terms,%20explained%20?
Before%20we%20dive%20in,%20it’s%20important%20to%20understand%20some%20of%20the%20key%20terminology%20related%20to%20leverage%20trading,%20as%20this%20can%20create%20some%20confusion.%20Take%20a%20moment%20to%20read%20and%20digest%20the%20following,%20and%20refer%20back%20to%20it%20if%20you%20need%20to.
Leverage refers%20to%20the%20act%20of%20multiplying%20your%20available%20capital%20from%20a%20trading%20platform%20to%20increase%20your%20position%20size.%20While%20you%20are%20not%20directly%20borrowing%20funds%20in%20the%20way%20you%20would%20with%20a%20loan,%20leverage%20allows%20you%20to%20control%20a%20larger%20position%20with%20a%20smaller%20amount%20of%20capital%20by%20amplifying%20the%20exposure%20to%20price%20movements%20of%20the%20underlying%20asset.
Leverage%20Ratio reflects%20the%20proportion%20of%20margin%20to%20leverage%20as%20a%20ratio.%20For%20example,%20using%2010x%20leverage,%20with%20$1%20of%20margin%20you%20can%20enter%20a%20$10%20position,%20hence%20the%20Leverage%20Ratio%20of%201:10.
Position%20Size refers%20to%20the%20notional%20amount%20you%20buy%20or%20sell%20in%20a%20long%20or%20short%20position,%20respectively.%20Your%20position%20size%20is%20made%20up%20of%20the%20initial%20margin%20plus%20the%20additional%20funds.
Risk%20per%20Trade is%20the%20amount%20or%20percentage%20of%20your%20trading%20capital%20that%20you%20are%20prepared%20to%20risk%20on%20a%20given%20trade.%20It%20is not the%20same%20as%20position%20size.%20You%20could%20have%20a%20position%20size%20with%20a%20notional%20value%20of%20$10,000%20and%20only%20be%20risking%201%%20or%20$100%20of%20your%20account%20balance,%20as%20described%20in%20the%20example%20below.
Collateral refers%20to%20assets%20(such%20as%20cash%20or%20cryptocurrency)%20that%20a%20trader%20pledges%20or%20locks%20up%20to%20secure%20a%20leveraged%20position.%20It%20acts%20as%20security%20for%20the%20amplified%20funds.
Liquidation is%20the%20forced%20closure%20of%20your%20position%20by%20the%20trading%20platform,%20and%20occurs%20when%20your%20margin%20drops%20below%20your%20maintenance%20margin%20level%20(your%20liquidation%20price).%20It%20is%20essentially%20a%20last%20resort,%20used%20by%20the%20platform%20to%20ensure%20that%20you%20do%20not%20incur%20losses%20beyond%20the%20funds%20available%20to%20cover%20the%20additional%20capital.
Equity refers%20to%20the%20total%20value%20of%20a%20trader's%20account,%20specifically%20their%20ownership%20value,%20including%20both%20the%20initial%20margin%20they%20deposited%20and%20any%20unrealized%20profits%20or%20losses%20from%20open%20positions.%20If%20Cross%20Margin%20is%20used,%20the%20entire%20equity—including%20unrealized%20profits—can%20be%20liquidated%20to%20cover%20losses,%20as%20some%20trading%20platforms%20will%20automatically%20close%20profitable%20positions%20to%20retrieve%20the%20necessary%20funds.
Funding%20fees are%20periodic%20payments%20made%20between%20traders%20in%20a perpetual%20futures%20contract market%20to%20help%20ensure%20that%20the%20price%20of%20the%20futures%20contract%20stays%20aligned%20with%20the%20spot%20price%20of%20the%20underlying%20asset.%20These%20fees%20can%20reduce%20your%20equity%20over%20time,%20which%20in%20turn%20can%20affect%20your%20ability%20to%20meet%20margin%20requirements%20and%20maintain%20open%20positions.
Margin trading is%20a%20broader%20term%20that%20refers%20to%20the%20practice%20of%20borrowing%20funds%20from%20a%20platform%20or%20broker%20to%20trade%20assets,%20allowing%20traders%20to%20open%20positions%20that%20are%20larger%20than%20their%20account%20balance.%20The%20borrowed%20funds%20allow%20the%20trader%20to%20enter%20trades%20with%20the%20goal%20of%20amplifying%20returns.%20It's%20important%20to%20note%20that%20margin%20trading%20and%20leverage%20trading%20are%20related%20but%20distinct%20concepts—margin%20refers%20to%20the%20funds%20used%20as%20collateral,%20while%20leverage%20refers%20to%20the%20multiplier%20effect%20on%20position%20size.
Margin is%20the%20portion%20of%20your%20collateral%20that%20is%20actively%20used%20to%20open%20and%20maintain%20a%20leveraged%20position.%20Essentially,%20margin%20is%20a%20fraction%20of%20the%20total%20position%20size,%20backed%20by%20the%20collateral%20you%20provide.%20There%20are%20typically%20two%20ways%20that%20you%20can%20choose%20to%20allocate%20collateral.
Cross%20Margin usually%20means%20your%20entire%20balance%20can%20be%20used%20as%20collateral%20(if%20a%20platform%20has%20a%20dedicated%20Derivatives%20Wallet%20it’s%20usually%20the%20full%20balance%20within%20that%20wallet).%20This%20would%20result%20in%20your%20liquidation%20price%20being%20further%20from%20your%20entry,%20but%20if%20the%20liquidation%20price%20is%20reached,%20you%20can%20lose%20your%20entire%20balance.
Isolated%20margin uses%20only%20a%20fraction%20of%20your%20collateral,%20which%20brings%20your%20liquidation%20price%20closer%20to%20your%20entry.%20This%20option%20can%20cap%20your%20losses%20to%20the%20specific%20collateral%20deployed%20for%20the%20position%20in%20question.
In%20addition,%20there%20are%20two%20types%20of%20margin%20to%20be%20aware%20of:
Initial%20margin is%20the initial%20amount%20of%20capital%20required%20to%20open%20a%20leveraged%20position.
Maintenance%20margin is%20the%20minimum%20amount%20of%20equity%20a%20trader%20must%20maintain%20in%20their%20account%20to%20keep%20the%20position%20open.%20If%20the%20equity%20falls%20below%20this%20level,%20a%20margin%20call%20occurs,%20requiring%20the%20trader%20to%20add%20more%20funds%20or%20face%20liquidation.
How%20does%20leverage%20trading%20work?%20?
To%20explain%20how%20leverage%20trading%20works,%20let’s%20imagine%20a%20scenario%20where%20a%20trader%20wants%20to%20take%20a%20leveraged%20position%20on Bitcoin%20(BTC).
In%20this%20example,%20based%20on%20their%20experience,%20research%20and%20backtesting,%20the%20trader%20believes%20that%20Bitcoin%20will%20significantly%20bounce%20from%20$50,000.%20But%20the%20trader%20has%20a%20two%20concerns:
As%20a%20trader%20on%20lower%20time%20frames,%20they%20want%20to%20profit%20from%20a%20small%20move—specifically%20from%20$50,000%20to%20$51,000,%20a%202%%20change.%20In%20order%20to%20make%20this%20trade%20worthwhile,%20the%20trader%20will%20need%20to%20put%20100%%20of%20their%20trading%20capital%20to%20work.
The%20trader%20is%20also%20concerned%20about%20counterparty%20risk.%20As%20the%20saying%20goes,%20“Not%20your%20keys,%20not%20your%20crypto”%20-%20money%20deposited%20on%20trading%20platforms%20is%20not%20fully%20under%20your%20control,%20because%20access%20to%20the%20funds%20depends%20on%20the%20platform%20in%20question.%20The%20trader%20could%20deposit%20all%20of%20their%20available%20trading%20capital%20onto%20the%20platform,%20but%20then%20it%20would%20be%20at%20the%20mercy%20of%20the%20platform's%20security%20protocols%20for%20the%20time%20it%20resides%20there.
Leverage%20goes%20some%20way%20to%20solving%20both%20of%20these%20problems.%20If%20we%20imagine%20the%20trader%20has%20a%20bankroll%20of%20$10,000,%20leverage%20will%20enable%20them%20to%20trade%20at%20the%20size%20they%20want,%20without%20needing%20to%20deposit%20more%20than%203%%20of%20their%20capital%20onto%20the%20platform.%20This%20is%20where%20leverage%20ratios%20come%20in.
Leverage%20ratios
Leverage%20ratios%20represent%20the%20extent%20to%20which%20a%20trader%20can%20multiply%20their%20position.%20Common%20leverage%20ratios%20in%20crypto%20trading%20range%20from%202:1%20(2x)%20to%20as%20high%20as%20100:1%20(100x).%20The%20higher%20the%20ratio,%20the%20more%20amplified%20the%20profits%20or%20losses%20will%20be.
In%20the%20current%20example,%20the%20trader%20wants%20to:
Take%20a%20position%20that%20reflects%20the%20size%20of%20their%20entire%20trading%20capital—in%20this%20case,%20$10,000—without%20having%20to%20deposit%20that%20capital%20onto%20the%20trading%20platform.
Every%20trader%20has%20numerous%20options%20with%20regards%20to%20leverage%20ratios,%20and%20can%20often%20tailor%20it%20to%20enter%20the%20exact%20position%20size%20they%20want,%20between%202x-100x:
With%202x%20leverage,%20for%20every%20$1%20you%20deposit%20as%20collateral,%20you%20can%20control%20a%20position%20worth%20up%20to%20twice%20that%20amount.%20For%20example,%20if%20you%20deposit%20$100,%20you%20can%20take%20a%20position%20size%20of%20$200.%20In%20this%20case,%20half%20of%20the%20$200%20would%20come%20from%20your%20own%20funds%20(the%20margin),%20while%20the%20other%20half%20reflects%20the%20amplification%20by%20leverage.
How%20you%20use%20your%20collateral%20and%20the%20leverage%20you%20use%20with%20it%20will%20affect%20your%20liquidation%20price.%20Higher%20leverage%20requires%20less%20collateral,%20which%20results%20in%20less%20margin%20meaning%20your%20liquidation%20price%20will%20be%20closer%20to%20your%20entry.%20Even%20relatively%20small%20fluctuations%20in%20price%20can%20lead%20to%20immediate%20liquidation%20when%20using%20high%20leverage.%20It’s%20critically%20important%20to%20check%20that%20your%20stop%20loss%20will%20be%20triggered%20before%20your%20liquidation%20price.
One%20other%20common%20misconception%20attached%20to%20leverage%20is%20its%20impact%20on%20position%20size.%20When%20you%20have%20determined%20the%20position%20size%20you%20want%20to%20take,%20increasing%20leverage%20will not change%20your%20position%20size.
If%20your%20desire%20is%20to%20open%20a%20$10,000%20position,%20you%20could%20do%20so%20using%2010x%20or%20100x%20leverage.%20Using%20the%20latter%20would%20not%20result%20in%20greater%20returns,%20and%20the%20position%20size%20would%20remain%20the%20same.%20Leverage%20allows%20you%20to%20open%20a%20position%20size%20greater%20than%20your%20account%20balance,%20and%20therefore%20higher%20leverage%20results%20in%20a%20greater%20amplification%20of%20your%20capital.%20More%20leverage%20simply%20requires%20less%20capital%20to%20open%20the%20same%20position,%20and%20comes%20with%20its%20own%20set%20of%20pros%20and%20cons,%20with%20respect%20to%20liquidation.
Because%20the%20trader%20in%20this%20example%20wants%20to%20enter%20a%20position%20of%20$10,000%20but%20doesn’t%20want%20to%20deposit%20all%20of%20their%20capital,%20they%20elect%20to%20deposit%20just%20$300%20as%20collateral%20and%20use%2050x%20leverage.%20This%20means%20that%20the%20trader%20needs%20just%20$200%20in%20initial%20margin—or%20two%20thirds%20of%20their%20collateral—to%20open%20a%20position%20that%20reflects%20their%20entire%20trading%20balance.%20The%20remainder%20will%20act%20as%20a%20buffer%20for%20the%20margin,%20preventing%20the%20position%20from%20being%20liquidated%20prior%20to%20the%20desired%20stop.
There%20is%20an%20important%20and%20perhaps%20unforeseen%20benefit%20here%20that%20relates%20to%20risk%20management:
To%20reduce%20their risk%20of%20ruin,%20the%20trader%20has%20committed%20to%20only%20ever%20risking%202%%20of%20their%20total%20trading%20capital%20on%20any%20given%20trade,%20an%20amount%20that%20is generally%20considered%20reasonable.%20By%20only%20depositing%203%%20of%20their%20$10,000%20account%20onto%20a%20leverage%20trading%20platform,%20the%20trader%20has%20also%20capped%20the%20maximum%20they%20can%20lose,%20in%20any%20scenario,%20to%203%.%20If%20the%20trader%20makes%20a%20careless%20error%20or%20the%20platform%20runs%20into%20difficulty,%20the%20maximum%20they%20can%20lose%20is%20$300.%20This%20is%20a%20really%20valuable%20precaution,%20because%20one%20honest%20miscalculation%20or%20mis-click%20while%20leverage%20trading%20can%20have%20devastating%20consequences.
If%20the%20trader%20only%20deposited%20$200%20then%20leveraged%20that%20amount%2050x,%20the%20position%20would%20actually%20be%20liquidated%20before%20it%20reached%20the%20stop%202%%20below%20entry.%20In%20actuality,%20the%20position%20would%20be%20closed%20somewhere%20between%201-1.6%%20below%20entry,%20depending%20on%20the%20trading%20platform.%20Depositing%20$300%20allows%20for%20enough%20maintenance%20margin%20to%20enable%20the%20position%20to%20remain%20open%20up%20until%20it%20reaches%20the%20intended%20stop.
Collateralization
Collateral%20refers%20to%20the%20assets%20you%20deposit%20to%20secure%20a%20leveraged%20position%20-%20it’s%20the%20capital%20you%20put%20up%20to%20secure%20the%20position.
In%20most%20cases,%20traders%20have%20the%20option%20to%20pledge%20fiat%20currencies%20like%20U.S.%20dollars%20or%20a%20variety%20of%20other%20cryptocurrencies,%20including%20Bitcoin%20(BTC)%20and%20Ethereum%20(ETH).
Some%20crypto%20trading%20platforms%20like%20Kraken%20offer multi-collateral%20wallets,%20enabling%20traders%20to%20use%20multiple%20digital%20assets%20simultaneously%20for%20enhanced%20flexibility.%20However,%20it’s%20worth%20mentioning%20that%20if%20you%20pledge%20part%20of%20your%20crypto%20portfolio%20as%20collateral,%20you%20won’t%20be%20able%20to%20use%20100%%20of%20its%20notional%20value%20as%20margin.%20This%20is%20due%20to%20the%20“haircut,”%20which%20is%20a%20mandatory%20reduction%20in%20value%20applied%20to%20collateralized%20crypto%20assets.%20The%20purpose%20of%20the%20haircut%20is%20to%20account%20for%20some%20of%20the%20additional%20risk%20in%20using%20a%20volatile%20asset%20as%20margin.%20In%20short,%20if%20you%20want%20to%20use%20crypto%20assets%20as%20collateral,%20you%20will%20have%20to%20accept%20a%20small%20haircut%20in%20its%20value%20before%20it%20can%20be%20put%20to%20work%20as%20margin.
Coin-margined%20contracts%20are%20another%20example%20that%20require%20a%20particular%20crypto%20as%20collateral.%20In%20this%20instance,%20any%20profits%20or%20losses%20are%20also%20realized%20in%20the%20same%20asset.
Example%20of%20leveraged%20long%20position
Returning%20to%20our%20example,%20the%20trader%20leverages%20$200%20fifty%20times%20and%20uses%20a bracket%20order to%20buy%2010,000%20contracts%20of%20Bitcoin%20(BTC)%20at%20$50,000,%20with%20a%20notional%20value%20of%20$10,000.%20The%20take%20profit%20is%20$51,000%20and%20the%20stop-loss%20is%20$49,000.%20Breaking%20this%20down%20further:
The%20trader%20deposited%20$300%20as%20collateral%20into%20their%20futures%20account,%20leaving%20the%20rest%20of%20their%20capital%20($9,700)%20on%20a hardware%20wallet.%20This%20can%20help%20to%20significantly%20reduce%20counterparty%20risk%20while%20still%20enabling%20them%20to%20trade%20their%20entire%20balance.
They%20then%20selected%2050x%20leverage,%20meaning%20they%20can%20open%20a%20position%20up%20to%2050x%20their%20collateral,%20which%20is%20$15,000.%20However,%20the%20trader%20is%20only%20interested%20in%20taking%20a%20$10,000%20position.
The%20trader%20opts%20for%20cross%20margin,%20which%20will%20use%20all%20of%20the%20available%20collateral%20to%20keep%20the%20position%20open,%20preventing%20the%20trade%20from%20being%20liquidated%20prior%20to%20the%20stop-loss.%20This%20does%20mean%20that%20the%20trader%20could%20lose%20more%20than%20$200%20if%20the%20market%20moves%20violently%20or%20there%20is%20insufficient%20liquidity.%20But%20again,%20the%20total%20potential%20loss%20is%20capped%20at%20$300,%20as%20this%20is%20all%20that%20resides%20in%20the%20account.
The%20initial%20margin%20is%20$200%20-%20this%20is%20how%20much of%20their%20collateral%20is%20required%20to%20open%20the%20position.%20In%20this%20instance,%20the%20initial%20margin%20represents%2066%%20of%20their%20collateral,%20because%20$200%20is%20required%20when%20using%2050x%20leverage%20to%20open%20a%20$10,000%20position.%20If%20the%20trader%20only%20wanted%20a%20position%20size%20of%20$5,000%20using%2050x%20leverage,%20their%20initial%20margin%20would%20be%20$50,%20only%20using%2030%%20of%20the%20collateral.
The%20expected%20reward%20to%20risk%20ratio%20for%20the%20trade%20is%201:1.%20If%20the%20price%20reaches%20the%20take%20profit%20of%20$51,000%20before%20it%20reaches%20the%20stop,%20the%20trader%20will%20realize%20a%20gain%20of%20$200.%20If%20the%20price%20reaches%20the%20stop%20of%20$49,000%20before%20the%20take-profit,%20the%20trader%20will%20realize%20a%20loss%20of%20$200,%20(before%20fees%20and%20any%20potential%20slippage%20costs).
The%20price%20of%20Bitcoin%20dips%20down%20to%20$50,000%20and%20the%20order%20is%20filled.%20Price%20fluctuates%20around%20$50,000%20for%20some%20time,%20and%20the%20trader’s%20equity%20moves%20up%20and%20down%20with%20it.%20After%20several%20rejection%20candles%20at%20$50,000,%20price%20finds%20some%20momentum%20to%20the%20upside,%20reaching%20the%20take%20profit%20within%20a%20couple%20of%20hours.%20After%20fees%20and%20funding,%20the%20trader%20realizes%20a%20gain%20of%20$199.50.
Example%20of%20leveraged%20short%20position
A%20leveraged%20short%20position%20is%20naturally%20the%20inverse%20of%20a%20long%20position%20with%20two%20key%20differences.
A%20long%20position%20involves%20using%20leveraged%20capital%20to%20buy%20contracts%20with%20the%20aim%20of%20hopefully%20selling%20them%20for%20a%20greater%20value.%20Short%20selling%20uses%20the%20exact%20same%20mechanics%20described%20above,%20but%20leverages%20capital%20to%20sell%20contracts,%20so%20that%20they%20can%20be%20sold%20into%20the%20market%20and%20bought%20back%20at%20a%20later%20date.
Short%20positions%20theoretically%20have%20unlimited%20risk,%20because%20an%20asset%20can%20continue%20increasing%20in%20value%20indefinitely.%20However,%20in%20a%20long%20position,%20the%20ultimate%20floor%20in%20price%20is%20zero,%20as%20price%20cannot%20go%20below%20this%20value%20(oil%20futures,%20notwithstanding).%20This%20means%20that%20your%20risk%20is%20capped,%20even%20if%20it%20is%20unlikely%20for%20a%20trader%20to%20hold%20a%20leveraged%20position%20to%20zero.
Hedging
Hedging is%20another%20way%20that%20leverage%20trading%20can%20be%20used%20to%20manage%20risk.%20Let’s%20imagine%20that%20you%20own%20some%20spot Ethereum%20(ETH) but%20are%20concerned%20that%20the%20market%20is%20about%20to%20reverse%20to%20the%20downside.%20Using%20leverage%20can%20help%20you%20protect%20your%20capital,%20by%20opening%20a%20short%20position%20that%20matches%20the%20size%20of%20your%20spot%20holdings.
Any%20depreciation%20in%20the%20price%20of%20spot%20ETH%20is%20offset%20by%20the%20unrealized%20gains%20of%20the%20leveraged%20short%20position.
For%20example,%20imagine%20you%20hold%201%20ETH%20in%20your%20portfolio,%20and%20decide%20to%20hedge%20this%201%20ETH%20at%20a%20price%20of%20$1,000.%20The%20price%20of%20ETH%20then%20drops%20to%20$900,%20meaning%20your%20spot%20position%20would%20be%20worth%20$100%20less,%20but%20your%20hedge%20would%20now%20be%20$100%20in%20profit.
As%20a%20result,%20in%20real%20terms,%20you%20have%20protected%20the%20capital%20parked%20in%20your%20spot%20ETH%20via%20the%20hedge.%20Naturally,%20if%20you%20were%20wrong%20about%20the%20market%20reversing%20and%20ETH%20rallied%20instead,%20any%20increase%20in%20the%20value%20of%20your%20portfolio%20would%20be%20offset%20by%20the%20unrealized%20loss%20of%20the%20hedge.
While%20hedging%20is%20a%20useful%20strategy%20for%20preserving%20the%20value%20in%20a%20portfolio,%20as%20with%20all%20leverage%20trading,%20it%20is%20not%20without%20risk%20and%20can%20go%20wrong. Many%20large%20companies use%20futures%20markets%20to%20hedge%20commodities%20for%20various%20reasons,%20but%20that%20doesn’t%20mean%20that%20the%20position%20will%20have%20a%20favorable%20outcome.
Like%20all%20trading%20strategies,%20hedging%20requires%20the%20same%20due%20diligence%20and%20research%20to%20increase%20the%20probability%20of%20success.%20If%20you%20are%20wrong%20about%20your%20decision%20to%20hedge,%20you%20may%20end%20up%20being%20worse%20off%20than%20if%20you%20did%20nothing.%20Also%20take%20into%20consideration%20the%20cost%20of%20funding,%20which%20can%20make%20a%20hedge%20costly.
The%20hedge%20is%20still%20a%20leveraged%20trade,%20with%20the%20potential%20for%20liquidation%20or%20significant%20loss%20if%20managed%20incorrectly.%20If%20you%20take%20a%20hedge%20position%20with%20a%20tight%20stop,%20the%20market%20could%20close%20your%20hedge%20before%20going%20in%20your%20favor,%20which%20would%20be%20a%20really%20unfortunate%20outcome.
Leveraged%20tokens
Leverage%20tokens%20offer%20an%20alternative%20to%20leverage%20trading,%20and%20remove%20the%20possibility%20of%20liquidation%20(though%20not%20significant%20losses%20altogether).
Rather%20than%20putting%20up%20collateral%20for%20margin,%20traders%20can%20simply%20buy%20a%20token%20with%20leverage%20built%20into%20it,%20effectively%20buying%20a%20spot%20asset%20with%20increased%20volatility.%20At%20some%20trading%20platforms,%20traders%20can%20trade%20leveraged%20tokens%20which%20move%20three%20times%20as%20much%20as%20the%20spot%20equivalent.
For%20example,%20if%20you%20bought%20$1,000%20worth%20of%20a Solana%20(SOL) 3x%20leveraged%20token,%20and%20the%20actual%20price%20of%20Solana%20went%20up%2010%%20in%20a%20day,%20this%20would%20be%20reflected%20as%20a%2030%%20move%20in%20the%20leveraged%20equivalent.%20This%20is%20an%20arguably%20simpler%20way%20to%20amplify%20gains%20(and%20losses)%20without%20using%20leverage.%20However,%20owing%20to%20value%20decay%20and%20daily%20rebalancing,%20these%20tokens%20are%20not%20suitable%20for%20long%20term%20positions.%20Holding%20them%20for%20extended%20periods%20can%20result%20in%20losses%20even%20if%20the%20market%20moves%20in%20your%20favor.
Pros and cons of leverage trading ✍️
Advantages of leverage trading
Risk management: Leverage allows traders to reduce counterparty risk and also cap their risk per trade in line with strict risk management guidelines. This is an immensely valuable feature that cannot be understated. Traders can also use leverage to spread their risk over multiple platforms, reducing the potential impact of being targeted and slippage.
Capital efficiency: Leverage allows traders to control large positions with a relatively small amount of capital.
Hedging: As described above, by taking a short position equal to assets in your portfolio, traders can mitigate the impact of potential downside in the market and preserve capital.
Profit from downside: While you can sell assets you own in spot markets to buy them back lower, leverage trading allows traders to profit from downside on assets they don’t own. This creates many more opportunities for traders to take advantage of.
Maximize gains: Traders can use leverage to generate outsized returns that would not be possible in spot markets. Once a position starts to generate an unrealized gain, traders are able to use the increase in margin balance to add to the position, which, if the position continues to go in the trader’s favor, will result in a larger overall gain. This process can be repeated to compound returns for as long the position remains open.
Managing risks of leverage trading
Potential for ruinous losses: As many traders have experienced, trading with leverage can have severe consequences. In many cases, this may result from a simple, honest mistake, owing to a lack of understanding about how leverage works. This is why it’s important to only use leverage if you have a confident grasp of the underlying mechanisms, and are able to safely manage risk.
Complexity: As demonstrated by the list above, there is a certain amount of complexity to leverage trading, and it can take a little while to understand all the moving parts. This makes it more challenging for novice traders and increases the probability of costly errors. In the UK, many traders are not able to access crypto derivatives products since the FCA banned them for retail traders, citing various reasons related to the potential harm they pose.
Time sensitivity: Because of the way that crypto futures contracts work, traders are both price and time sensitive. They are price sensitive because they naturally need the market to move in their favor to realize any gains. They are time sensitive because of the cost of holding a position in certain conditions. If a trader enters a long position when funding is significantly positive, they will have to pay a fee every few hours to hold the position (when funding is positive, longs pay shorts). These fees can add up, and over a long enough period can significantly dent the profitability of a trade. At a certain point, if the market fails to move in their favor over a long enough period, a trader may be paying so much in funding that they may decide to close the position. Put simply, traders paying outsized funding fees need prices to move in their favor within a reasonable time frame, whereas a trader who simply holds a spot position does not have the same problem.
Vulnerability to exploitation: Crypto markets often have sharp, volatile movements that catch many traders offside, forcing them into liquidation. A short squeeze is one example - price rapidly spikes, forcing short sellers to cover. These types of moves tend to occur when futures traders are vulnerable, where putting them under pressure will generate liquidity. Take into account also that crypto trades 24/7, and many traders may be caught off guard when they least expect it.
