Crypto Leverage Trading: A Comprehensive Guide to Amplify Your Profits in Crypto Trading | LiteFinance (2024)

Leverage in cryptocurrency trading works on the same principle as in the Forex market. This tool allows traders to increase potential profits using broker funds. However, at the same time, it increases the risks. Excessive use of leverage can lead to the loss of most of the funds.

After reading this article, you will learn how leverage works in cryptocurrency trading and what advantages and risks it provides. The article also covers the topic of how to manage risks so that borrowed funds bring profit.

Key Takeaways

What Is Leverage in Crypto Trading

First, let's look at leverage in trading and margin trading. There aretwo basic types of trades:

• long trades;

• short trades.

In long trades, traders buy assets at a fixed price and sell them at a higher price. Thus, traders can make a profit, even without the participation of an exchange or broker, simply by buying cryptocurrency and reselling it.

Short trades are based on a different principle. A trader borrows an asset from a broker, sells it, and after the price falls, buys tokens and gives them back to the broker. When trading cryptocurrency without leverage, all trades are opened at the current market price using funds available in a trader's account. However, short trades already refer to margin trading, even whentrading without leverage, since traders borrow an asset from a broker.

Leverage in cryptocurrency trading provides enhanced purchasing power to traders through borrowed capital. Using leverage allows traders to multiply the size of their positions and increases the potential for higher profits.

However, since only the account's free balance is used as collateral, it is important to remember that the market may move against your position. The higher the leverage ratios, the greater the profit when the price moves by one pip, but also the closer the liquidation level, which can lead to significant losses.

If you want to try leverage trading for the first time, check outthe guide for beginner traders.

The chart above shows the profitability of BTCUSD trading using leverage (green line) and without it (yellow line).

How Trading With Leverage Works

To use leverage, traders must have a margin deposit. The positive account balance serves as collateral, since the transaction is partially secured at the expense of a trader’s funds. The higher the leverage ratios, the smaller a trader's share. The remaining amount is paid by the broker.

After opening long/short trades, traders need to maintain a certain margin threshold. For most brokers, margin requirements are limited to 25%. If there is not enough margin, the broker issues a margin call with a requirement to replenish the account and starts the procedure for forced trade liquidation. This is a necessary procedure that does not allow the account balance to go to negative values, so a trader will not have a debt to the broker for the loan issued.

Example of Leveraged Long Position

To better understand what leverage is, let’s look at how it works using the data below:

• trader’s balance: $100;

• lot: $1000;

• coefficient: 1:50;

• trade type: long.

To use leverage to open a long position with a volume of $1000, a trader must have collateral of 1000/50 = $20. It seems that leverage in cryptocurrency trading does not require much investment, but this is true as long as the price moves in the predicted direction. Even if the market declines by just one dollar, the margin at the specified ratio will increase by $50. If it decreases by $2, the funds available on the balance will no longer be enough to continue trading with leverage. Because even before the quotes go down by $2, a margin call will trigger; that is, the position will be liquidated.

If a trader chooses a lower leverage ratio, the liquidation risks will be lower. For example, using 10x leverage, a $1 price drop would only increase the required margin by $10.

In a positive scenario, borrowed funds will bring significant profits to a trader. If the price goes up by only $3, using a leverage ratio of 1:50, a trader's net profit will be $150.

Example of Leveraged Short Position

Let's consider the features of borrowing assets and leverage trading using the data below:

• trader’s balance: $5,000;

• lot: $10,000 to buy BTC;

• coefficient: 1:50;

• trade type: short.

If you use 1:50 leverage to open a trade with a volume of $10,000, your initial margin will be 10,000/50 = $200. With a subsequent price decrease, a trader will earn $50 for each dollar of decline in the coin’s exchange rate. If the price reverses, surpassing the entry point into the market, then every dollar of price growth will bring $50 dollars of loss. Accordingly, with a balance of $5,000 and an initial margin of $200, the trade will be liquidated when the price rises by $96.

The diagram above shows how short trading with leverage works. A trader borrows Bitcoin at a high price and sells it at the market price. After the price falls, a trader buys back Bitcoin for the full amount. Since the price of Bitcoin is lower, its quantity is greater. A trader then returns the amount of BTC he/she borrowed and keeps the difference as profit.

Leveraged Tokens

Over the years, a new type of leveraged token has emerged. In addition to Bitcoin, Ethereum, Tether and so on, traders may come across strange names like 3x short Ethereum.

Leveraged tokens are assets that are typically developed using the ERC-20 or EVM-compatible protocols. These tokens are easy to use and are traded on the exchange along with other assets. On the other hand, they allow traders to increase returns from changes in underlying asset prices using financial leverage without the need to manage margins or borrowings.

These tokens have a distinct advantage over opening margin trades, as there is no need to worry aboutmargin security andliquidation levels. At the same time, it will not be possible to hold leveraged tokens for a long time due to the built-in automatic rebalancing mechanism.

This mechanism allows traders to maintain leverage at a given level, but at the same time it can adjust the value of the token. In addition, its use may include additional fees associated with rebalancing and other costs.

Since such tokens can automatically rebalance, their value may be affected by sudden market movements in either direction. Unlike regular ERC-20 tokens, traders cannot withdraw them to their wallets, and additional fees may apply when holding them.

If there is a flat market and the price does not move along the trend for a long time, rebalancing and other fees will lower your balance. These costs can be significantly higher than an open margin trade with a similarleverage level.

Why You Should Trade Crypto With Leverage

Traders use leverage to increase profits per trade. However, as demonstrated above, leverage trading can also lead to serious losses.

Another reason for using leverage is to increase capital liquidity. For example, instead of holding a 2x leverage position on one exchange, a trader can choose 4x leverage to maintain the same position size with less collateral. This will allow him/her to use part of the money in another trade. For example, for trading another asset, staking, providing liquidity to decentralized exchanges (DEX), investing in NFTs, and so on.

Pros and Cons of Leverage Trading

Trading with leverage has pros and cons. Proper use of leverage and risk management allows traders to make large profits, with virtually no downsides. The final trading result depends on the effectiveness of the strategy and the trader’s ability to assess market sentiment.

Below is a table with the main advantages and disadvantages of trading cryptocurrency with leverage.

Advantages of leverage trading

In the world of cryptocurrencies, leverage is used to increase traders' financial capabilities, primarily to increase profits. Financial leverage allows traders to gain access to higher-priced investment options that investors with less initial capital do not have access to.

Leverage can be used in short-term trading when a lot of capital is required or when a trader is confident in future price movements and wants to maximize profits.

Disadvantages of leverage trading

However, there is one major drawback. When using leverage, there is a risk of liquidation. If the market moves against your position, high leverage creates a huge margin burden.

If you are a novice trader, I do not recommend using leverage until you gain enough trading experience in regular trading. Improper use of leverage can be fatal for a trader.

Risk management skills are crucial when working with leverage. Never trade on borrowed funds or money you cannot afford to lose.

Managing Risks of Leverage Trading

Adherents of margin trading are constantly improving methods of effective risk management. This allows for the maximum efficient use of leverage without fear of facing a margin call.

One of the basic methods is to choose a leverage ratio that allows for significant market drawdowns. This is especially true in crypto space, which is characterized by increased volatility and lower predictability compared to Forex.

Experienced traders impose additional limitations for individual instruments. For example, if you plan to use leverage for trading during a sideways market, it makes sense to choose a ratio of 1:5 instead of 1:10. For trading in trending markets, on the other hand, higher ratios are permissible. Especially if your trading strategy involves opening long or short trades during an established trend.

The following tools can help to minimize losses when using leverage:

• Stop-loss is used to automatically close a trade if the market moves against the trade. When trading cryptocurrencies, it is recommended to set stop-loss orders at the nearest local low to prevent serious drawdowns and liquidation.

• Take-profit is a pending order that automatically locks in profits when the price crosses a predetermined level. It can be especially useful for beginners who find it difficult to predict when the price will reach target values.

• Limit order is a pending order to execute a trade at a predetermined price.

• Trading plan. Plan in advance the price for entering the market, for stop loss, averaging and increasing a position, and taking profit. Do not deviate from your trading plan.

• Isolated margin is used to limit losses by opening trades. In case of liquidation, you will lose only the funds allocated for an isolated margin in a specific trade, not your entire deposit.

• Liquidation Level Management. Always monitor the liquidation level. It should be at a safe distance from your position. When calculating the liquidation level, consider the instrument's volatility and the stop level in your trading plan.

The main rule for leverage is disciplined and responsible trading. Always consider possible risks. It is better to choose less leverage and get less profit than to learn from your own experience what liquidation risks are.

Leverage Trading in Spot vs Derivatives

Even if you are a novice trader, you have probably heard about spot markets. It's the simplest way to trade, offered by almost all centralized crypto exchanges.

The distinctive feature of the spot market is that it deals with trades backed by real assets. A traditional spot market is the commodities market (oil, metals, grains), where all trading is done through an order book.Trading cryptocurrency is similar. It's assumed that all trades on the spot market are backed by crypto on a 1-to-1 basis. Traders can always withdraw these funds.

Spot trading is typically done using a trader's own assets andwithout leverage. However, traders who prefer trading with leverage can also trade on the spot market. It's important to note that leverage on the spot market is lower, and commissions are higher.

Leveraged tokens are also a leveraged tool for trading on the spot market.

When trading derivatives, you are not trading a real asset but a contract that guarantees its security.Derivatives are divided into perpetual and futures contracts. Perpetual derivatives are the most popular in the Forex and cryptocurrency markets, as they are a simpler and more liquid trading instrument.

A distinctive feature of derivative financial instruments is the possibility of using large leverage. Often it exceeds the ratio of 1:100 and even 1:500. Another advantage of using derivatives is the relatively low fees.

Regulatory Considerations

Massive complaints from inexperienced traders about loss of capital due to leverage have led to some states introducing licensing, additional restrictions, or even prohibiting brokers from using leverage at the legislative level.

For example, in Canada, the CSA banned using leverage when trading cryptocurrency after an incident with the FTX crypto exchange. Regulator officials explained their decision by saying that trading in virtual currencies should ensure the safety of traders from unreasonable risks. The ban on margin trading affected both institutional investors and private traders. Similar restrictions, but only for retail traders, were recently introduced in Singapore.

In Australia, financial authorities have introduced regulation of acceptable leverage ratios for various financial instruments instead of a complete ban. Since 2020, margin trading of cryptocurrency is allowed with a maximum leverage of 1:2, which eliminates the benefits of leverage. At the same time, trading with a leverage of 1:2 in terms of risk level is not much different from trading without leverage.

The financial authorities of the Russian Federation similarly approached the problem. In September 2023, the Bank of Russia created a new category of brokerage company clients. It includes clients with an initial level of risk who have been trading with leverage for less than a year. For this category of clients, the regulator introduced lower leverage ratios relative to investors with a standard risk level. The latter are allowed to trade with leverage up to 1:3, but for beginners, the coefficient can be reduced to 1:1.4.

Real-Life Trade Examples

To better understand the concept of leverage and its benefits, let's look at a real-life example of successful leverage long trading:

• trader deposits 500 US dollars in USDT;

• then the trader decides to use leverage with a ratio of 1:20, since he/she considers trading with a large ratio too risky. When using such leverage, the total value of a potential lot increases to $10,000;

• the trader opens a long trade on the Ethereum market in the amount of $5,000 at a market price of $2,705 after breaking out the important psychological level of $2,700;

• the trader then sets a stop loss at $2,690. A $15 drop in Ethereum price would result in a loss of $55.45;

• during the day, the value of the coin increased to $2765;

• At this level, the ETHUSDT pair experiences strong resistance, and the trader decides to take profit. As a result, he/she received a profit of $221.81 with a risk of losing $55.45.

Below is another example of making a profit, this time during short-term trading:

• the trader deposits $1000 in USDT into the trading account;

• he/she then decides to use a 1:10 ratio to trade various crypto assets. This leverage and the overall cost of entering a short position in the cryptocurrency market is considered relatively risky. At the same time, the trader’s purchasing power increases from $1,000 to $10,000. With higher leverage, an unexpected market reversal can lead to the rapid liquidation of the entire deposit;

• trader opens BTC short trade at $63,090 after receiving strong seller reaction to the price approaching $64,000 and the start of a correction.

• the trader then sets a stop loss at $64,150. In a negative scenario, a price increase of $1060 will result in a loss of $168;

• the trader expects that the correction can reach the level of $60,000, so he/she sets a take profit with a margin of around $60,153;

• within 30 minutes the price drops sharply to $60,153, and the trader makes a profit of $465.52 with a total risk of $168.

Both examples demonstrate the potential for increasing profits through the effective use of leverage. When using borrowed funds to increase buying or selling power, do not choose a ratio that is too large, and also use stop losses and take profits.

Conclusion

Leveraged trading allows traders to make good profits, even with a modest initial investment. By using broker funds, it is possible to increase your purchasing power by 10, 50, and even 1000 times.

However, along with potential profits, the risk increases proportionally. Irrational use of large leverage has repeatedly led novice traders to lose all their funds. This is why you need to be careful when using this tool, especially when it comes to cryptocurrencies because the volatile crypto market creates increased risks of losses.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.