The Concept of Leverage Trading in Crypto

Cryptocurrencies are becoming more popular with every passing day. The questions on everyone's minds have shifted from "what is" to “how do I get involved?”, “how do I profit from cryptocurrencies?”, “where can I buy cryptocurrencies?”.

There seem fewer people who don't know what cryptocurrency is all about. The concept of digital currencies, which are independent of central agencies like the federal government and central banks, initially shook the world, but soon became a huge point of interest.

2021 recorded a massive rise in cryptocurrencies, non-fungible tokens (NFTs), decentralized finance (DeFi), and blockchain applications. This rise came with a surge in daily and cumulative transaction volumes as many corporations and individuals looked to take their own share of the once $2Trillion market (as of August 2021).

This inflow and outflow of billions of dollars daily trigger many people to want to maximize profits in whatever way possible, even if it means borrowing to open larger positions on a trade which increases potential profit (and well, loss too). Here's a basic primer on how leveraged crypto trading works.

The Concept Of Leverage Trading

Why make a 10% profit with your limited capital, when you could make more profit with extended capital? Leverage trading helps a trader or investor make the most out of a correct market prediction. Unfortunately, it also has the same increased impact when the trade goes against your prediction.

Leverage trading increases your position size for increased profits, and it also leaves you vulnerable to increased losses. The extent to which a trader can leverage a trade varies with different exchanges and has become attraction points used by brokerages to reel traders to their platforms.  

How Leverage Trading Works

One important thing to note is that leverage trading works with ratios; 1:10, 1:50, 1:100, 1:500, up to 1:1000. What this means is, if you want to invest $1000 in a digital asset at a leverage of 1:10, you will need to open a position with $100 only. A leveraged trade like this gives you a 10x potential profit and a 10x potential loss.

Opening a position in trading can either be long or short. So, if you believe a digital asset or assets will rise in value, you open long positions on them. The reverse is the case for short positions.

For example, in spot trading, going short on Bitcoin means borrowing Bitcoin, which you sell afterwards. If the price drops, you buy the Bitcoin at a lower price, and then return the Bitcoinby selling it, , and keep the profits.

To open long positions on a leveraged trade, a trader must maintain an amount in his account as collateral. If his trade goes well, the broker returns his initial deposit plus profit. If the trade flops, the broker retains the money and liquidates the position. Proper risk management recommends you use lower leverage to reduce the chances of liquidation.

Leverage And Volatility In The Crypto Market

Does leverage create volatility in the crypto market? Questions around the impact of leverage and volatility in Bitcoin's market have been a focal point in crypto discussions, as few understand their relationship.

There are a number of reasons why Bitcoin is highly volatile, and among them is leverage. For example,

  • Bitcoin's relative newness as an asset class is responsible for its continuous price discovery, which in turn causes volatility.
  • Bitcoin's limited supply at 21 million to hedge against inflation is also a factor that contributes to its volatility.
  • The absence of a proper regulatory framework for Bitcoin leaves it open to price manipulation and influence from whales and other capital intensive institutions, which induces its own volatility.

What many don't know is that leverage, the excessive use of it by traders, is also responsible for volatility in Bitcoin's market. Using leverage increases the chances of liquidation, that is, a quick, brutal, and total loss of capital should the market go against your prediction. Because Bitcoin is a highly volatile asset, the excessive use of leverage by traders tends to liquidate a lot of accounts when the market goes against the highly leveraged bets. This situation adds extra sell pressure on Bitcoin, because these traders hold collateral in it, and when their positions get liquidated their BTC gets sold. That is, of course, not true for sophisticated traders who reasonably hedge their positions or structure their bets in such a way that a sudden bear market won’t result in significant losses.

Common Leverage Trading Instruments

The most adopted way of leveraging trades is through derivatives. Derivatives, in all simplicity, are an agreement between two parties or more, whose value is determined by an underlying financial asset.

Considering Bitcoin, Sam believes BTC will increase from $40k next week, and Jane believes BTC will drop to $30k from next week. They both enter into a contract that says, if BTC rises to $50k next week, Jane will pay $10k to Sam, and if BTC drops to $30k, Sam will also pay Jane $10k. This shows that derivatives allow a trader profit both ways in the market, making it widely adopted by traders.

Cryptocurrency derivative trading volume. Source:TokenInsight

There are different types of derivatives contracts which include:

Bitcoin Futures: This is a derivative contract that involves two parties agreeing to buy and sell BTC at a predetermined date. None of the parties is obligated to hold an actual BTC, they just decide to settle the contract in a preferred local currency.

Bitcoin Options: This contract gives investors the option to buy or sell Bitcoin at a predetermined price and date. It is similar to Futures contract, only that they don’t have to be triggered.

Bitcoin Perpetuals: Perpetuals do not have a specific date or price limit. A trader can open a position for as long as he likes, so long as certain conditions are met.

How Does Leverage Trading Impact Bitcoin Price?

Is the presence of leverage bad or good for the Bitcoin market? It might be easy to conclude it's bad, considering excessive leveraging was largely attributed to the May 2021 Bitcoin crash. But, it will also help to consider the role of leverage in crypto markets asides volatility.

Leverage adds an important factor to the Bitcoin market, liquidity. And the presence of high liquidity in the market ensures efficiency in trade execution at specified prices, leading to a much improved price discovery for market makers. For instance, based on data gathered by TokenInsight across 42 exchanges, the crypto derivatives market had a trading volume of over $2 trillion in 2020.

Leverage trading in itself is healthy for the market, but the excessive use of it is what causes harm to the Bitcoin market. Where greed is curtailed, and effective risk management is used, leverage trading will continue to positively affect the Bitcoin market.

Pros And Cons

It's no news that everything has its good and bad sides, leverage trading inclusive. Leveraging trades increases both the profit and loss potential. This makes it risky if you don't know how to go about it. Adequate understanding of the financial markets and technical analysis is needed, though not enough most times.

A couple of advantages for leverage trading are:

  • Increased profit,
  • Helps you diversify your portfolio, and
  • Disciplines you into proper risk management.

In contrast, a major disadvantage of leverage trading is the higher risk and losses that come with it.

A Little Advice

Being profitable involves knowing when to leverage and when not to. Fundamental understanding of the markets cannot be overemphasized, alongside technical analysis, fundamental analysis, and sentimental analysis. Leverage trading is a profitable financial instrument but can be costly if used wrongly.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.