Leverage Trading: What It Is and How to Use It
Leverage trading is a way to increase your profit margins without investing or holding significant capital. It is common in various financial markets like stocks, forex trading, indices, commodities, exchange-traded funds (ETFs), and treasuries. It has also become a popular trading tool in the crypto space.
It is a helpful tool for investors when they don’t want to pay the listed value of an asset upfront or choose not to own assets. Investors can borrow funds from a broker (often an exchange) and increase their trading position well above what their cash balance allows.
Although profits can be amplified, the downside of this trading strategy is that losses can also amplify.
This article has an in-depth look under the hood of leverage trading, provides examples, when to use leverage, and looks at leverage trading strategies. Trading with this tool can also be a double-edged sword because potential profits can increase, but the exact mechanism applies with a possible loss. Hence, we look at some advantages and disadvantages of using leverage when trading.
What is leverage trading and why it’s important
Leverage trading is when an investor amplifies his buying power in the market. This happens when an investor borrows an ‘X’ amount of money and invests the borrowed money. As a result, the position size can be increased, and potential returns can be magnified. In addition, it allows traders and investors to gain exposure well beyond what their deposit amount allows them.
By using leverage, the investor can amplify his trade by a ratio of 2, 3, 5, 10, 25, or even up to 100. This will be written as 1:2, 1:3, 1:5, 1:10, or 1:25, and so on. This is leverage, the ratio by how much investment can be increased. The margin, on the other hand, is the amount of capital needed for opening a trade. For example, a trade with 1:25 leverage means that with $100, an investor can trade for $2,500, and the margin needed to open this position is $100.
Once traders or investors close a position, they return the borrowed money to the broker and keep the profits. This may sound very appealing to traders and investors since there is an immense potential for profit gains. However, the downside is that when losses occur, they magnify as well.
When traders or investors use an amount of leverage, it is crucial to be aware of the risks involved when trading with higher leverage. A margin or capital can be wiped out quickly when a leveraged trade is too high. Especially novices in the crypto space should use leverage prudently and not use all available leverage. Experienced traders can and will wait for the right moment before they use leverage. They wait until advantages are as much as possible on their side.
How does leverage trading work?
Leverage trading works by borrowing money from a broker, which can be an exchange, but it doesn’t have to be. This is most likely used as a trading strategy by advanced traders when trading short-term price movements. However, trading these price movements is largely dependent on the timeframes set by the traders which can be even up to a month! For longer-term investments, buying and holding assets is a more appropriate strategy.
Part of risk management during leverage trading is to start trading with lower leverage than the maximum leverage allowance. In this situation, when a trader experiences negative returns, a position can still be kept open for the full size.
With significant leverage and an increase in the asset’s value, the amount owed to a broker comes out of the profits made on the trade. On the other hand, if the trade ended with a loss, the broker will take it out of a trader’s account holdings or the collateral they use.
The higher the ratio of leverage used, the fewer margin traders need. For example, a 1:2 leverage requires a 50% margin. When using a 1:10 leverage, a trade requires only a 10% margin.
Here are a couple of examples to explain this in an easy-to-understand way. Let’s say a trader has $10,000 as capital in a broker’s account and wants to invest in a token or a stock using 1:2 leverage. This requires $5,000 cash and borrowing $5,000 from a broker using the cash and stocks as collateral. The assets value rose to up to $13,000 and then was sold. The broker receives his $5,000 back, leaving the trader with $8,000. The profit is $3,000 on this leveraged trade or a 60% profit.
With just a $5,000 cash investment, the trader would have made $1,300 or a 30% profit.
When using leverage, larger amounts of stock can be purchased, and profits are potentially higher, but losses multiply with the same percentages.
Leverage trading on a CEX
Leverage trading on a centralized crypto exchange typically works with the exchange being the broker. Traders borrow money from a CEX, but the principle remains the same. A trader gains exposure to a large sum of cryptocurrencies without paying the full amount or value of the trade upfront. A small deposit, or margin, is all that is required. When closing the leveraged position, the full size of the trade will determine the profit or loss.
Leverage can vary from 1:5 to 1:100. For example, Huobi Futures even offers a 1000x max margin. However, these options are usually only available for trading in futures and perpetuals. With derivatives, the max margins vary from 3.3 to 20, depending on the exchange.
Trading on a CEX also involves spot trading. This can be extended with margin trading with the use of leverage, usually up to 1:10. However, not all trading pairs allow for leveraged trading.
When trading on a centralized crypto exchange, they implement extensive KYC (know your customer) and AML (anti-money laundering) procedures. It is a standard requirement for all centralized exchanges to comply with regulatory rules and laws. Approval of these applications can take a week or longer.
There are options for trading in crypto without stringent KYC and AML procedures. These options are available in decentralized finance (DeFi) with decentralized exchanges (DEXs). You can think of DEXs as direct peer-to-peer (P2P) crypto marketplaces.
Leverage trading vs. spot trading
Spot trading and leverage trading are quite different. With a leveraged position, there is a potential for more profit but also more loss. Therefore, choosing spot trading or leveraged trading strategies boils down to a risk vs. reward consideration.
Trading in crypto is, in general, considered to be much riskier compared to trading on a stock market, with commodities, indices with CFD’s, or with a forex trading account. Price swings of 10% are not unusual; even the better-known coins like Bitcoin suffer from this volatility.
Spot trading is when you trade ‘on the spot,’ which most centralized crypto exchanges offer as their standard trade option. A trader needs to have an account with a balance to purchase any crypto. For example, if a trader wants to buy Ethereum for $2,000, he will need to have a balance of $2,000 in his wallet.
The best-known rule when investing is not to invest more than you can afford to lose. Spot trading makes things relatively simple.
The exchange requires a trading fee, ranging from 0.1% to 2.5% or more when trading. Therefore, it is well worth checking the trading fees before starting to use any trading platform.
The mechanics are very straightforward. For example, if a trader buys one Bitcoin for $60,000 and the price goes up 10% to $66,000, there is a profit of $6,000. However, if the price drops 10% to $54,000, there is a loss of $6,000. By using a stop-limit order, this risk can be mitigated.
Most crypto exchanges allow margin trading. This is similar to leverage trading, where the margin can enter a leverage position like 1:5 or 1:20. Respectively, 20% or 5% margin is needed to open these positions.
Let’s say, for example, that a trader now wants to buy one Bitcoin at $60,000 with 1:20 leverage. The margin needed is 5% or $3,000 in collateral. The other $57,000 is borrowed. With a 10% increase in value to $66,000, the trader makes 100% profit and doubles his money.
With a 10% drop in value to $54,000, the trader lost twice as much as he started, meaning that the loss is a staggering 200%. However, this is not the typical way these trading strategies work because the exchange or lenders don’t want you to lose that much money. They are looking after their interest and want to make sure they are being repaid.
A margin call is comparable to a safety net issued by the exchange. For example, when the Bitcoin mentioned above drops to $57,000, the trader is about to lose his collateral. This requires more collateral, sometimes even very quickly if a price drops fast. If the trader can’t meet the margin call because there are no further funds available or acting too slow, the position gets liquidated.
The exchange closes the position automatically, selling off the collateral to the lenders. Besides the principal, they may also want interest, and the exchange can charge fees.
Leverage ratio formula
For traders using leverage, it is essential to understand how to calculate the leverage ratio formula. It’s an easy-to-remember formula:
L = A / E
L stands for leverage, E for equity or margin, and A for assets.
Consequently, finding the leverage ratio is when a trader divides the asset amount by the margin amount.
Benefits and risk of leverage trading
Benefits of leverage trading
- More assets can be purchased with just a fraction of the cost, amplifying buying power.
- Many brokers offer negative balance protection.
- A higher profit potential on all trades.
- Many regulated exchanges offer this.
- Market exposure expands.
- High-value assets are accessible.
Risks of leverage trading
- Amplified losses, well above initial capital.
- Risk of margin calls.
- Profits may be taxable.
- Retail traders have restricted leverage.
- Interest and fees can nullify profits.
- The outcome can be unpredictable.
Leverage trading strategies
Leverage trading involves risk, and some well-tested strategies can help to mitigate these risks. On the other hand, these strategies can help with increasing the chances for profit. A few basics should always be attended to when engaging in such high-risk trades.
First, make sure that there is an understanding of how much loss can occur when trading, based on each person’s financial situation. With leverage trading, there is no room for guessing. Second, use a detailed analysis before opening a position. A stop-loss order minimizes risks and can be considered the first step to take. Set up a take-profit order to ensure profits are gained and not missed out on.
Some strategies include:
- Swing trading — for short to medium term while capitalizing on up and down movements. With leverage, more significant price shifts can be achieved. Best done during trading hours only, to avoid price gaps during closed markets when a trader can’t exit a position.
- Scalping — when used as arbitrage, positions are opened and closed in very short time frames, usually minutes. It’s performed in high frequency, so small profits rack up at the end of the day. High leverage increases profit opportunities, which is not recommended for beginners. It requires total commitment, proper training, and a fair amount of capital.
- Day trading — all trades are made within the same day. Price movements are usually small. Hence, traders use high leverage to increase profit.
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Wrapping it up
Leverage trading is a commonly used buying and selling strategy. Traders borrow money to invest and increase their chance of profit. The downside is that a potential loss is also magnified.
Therefore, it is vital to understand the risks that are involved when using leverage trading. This can help determine if this trading strategy is the right one regarding personal circumstances and financial situations. Therefore, it is an excellent idea to start with a demo account and get some practice.
With the right experience and risk assessment, trading opportunities can present themselves with just a little capital required to start.