Leverage Trading in Crypto Markets

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WHAT IS CRYPTO LEVERAGE TRADING?

Crypto leverage trading is a way of trading in crypto markets with more money than you have - essentially, it involves borrowing money to make bigger trades. Leverage trading is a high-risk, potentially high-reward activity. Using leverage will increase your gains on successful trades, but will also magnify your losses if your trade doesn’t work out, so make sure to understand the risks before you try it.

SUMMARY

Leverage trading may seem difficult to understand for beginners, so in this article we will cover the following:

• How Leverage Trading Works
• Examples of Leverage Trading
• The Advantages and Disadvantages of Using Leverage
• Where to Trade Using Leverage

HOW DOES LEVERAGE TRADING WORK?

Leverage trading involves borrowing money to make larger trades. To borrow this money, you are required to put down a deposit, known as ‘margin’ into an account on an exchange or a lending platform. Depending on the exchange’s rules, you will be able to borrow up to a set amount to increase your trade size. Different exchanges offer different leverage limits for different markets - so make sure you check the specific exchange’s rules first.

The ‘margin’ or collateral you deposit, serves as the exchange’s guarantee in the event of downside - if your trade is unsuccessful, the exchange either keeps the collateral or penalizes you in other ways.

When you deposit money into an exchange, you will often be offered the choice to deposit it to a margin account, or futures trading account, so that you can use leverage. Your deposited funds can then be used to borrow money and trade on leverage.You can then choose an amount of money to borrow, to raise your position size - depending on the exchange’s limitations & the rules for the specific trading pair. 

EXAMPLES OF CRYPTO LEVERAGE TRADING

WHAT IS 10X LEVERAGE IN CRYPTO?

Let’s look at an example of using 10x leverage:

Let’s say you deposit $100 of margin to your margin account, and you would like to buy Bitcoin.

With your $100 margin, you can buy up to $1000 of BTC using 10x leverage. If BTC's price rises by 10%, your leveraged position would increase from $1,000 to $1,100. This represents a gain of $100. You could now close the position by selling the BTC for $1,100, pay back $900 to the exchange, and be left with $200, $100 more than what you started with.

This $100 gain is a 100% increase on your original $100 margin (in practice, you’ll also have to subtract a small amount for the fees to pay the exchange for the trade). If you had not traded with leverage and instead simply bought $100 of BTC with your margin, that 10% price increase would have only resulted in a $10 gain.

This gives you an idea of the higher potential returns of leverage trading - but, as we’ll discuss later, this higher potential comes with higher risk of loss as well.

WHAT IS 20X LEVERAGE IN CRYPTO?

Let’s look at another example. This time using 20x leverage:

Let’s say you use $1,000 of margin in your account, and you would like to buy Ethereum.

Your $1,000 margin will allow you to trade with a position size of $20,000 of Ethereum on 20x leverage (20 times $1,000).

This means that for a 10% move upward in Ethereum, your account balance will increase by 200%. A 10% rise in the price of Ethereum would bring your leveraged position from $20,000 to $22,000 - a gain of $2,000. This $2,000 gain is a 200% increase on your original $1,000 margin (as before, you’ll have to subtract a small amount for the fees to pay the exchange).

THE RISKS OF USING LEVERAGE IN CRYPTO TRADING

Leverage trading is very risky. Just as the gains from a price increase are multiplied, so are the losses from a price decrease. Using too high an amount of leverage may cause you to get unexpectedly liquidated if a market is volatile - and lose your collateral. Here’s an example, to illustrate the risk you’re taking with high leverage:

Let’s build upon the example for 10x leverage from above. You deposited $100, and borrowed $900 for a total position of $1000 in BTC. If, instead of increasing 10%, BTC’s price drops 10%, your position is now worth $900, the same amount you owe the exchange.

To ensure you can repay the loan, the exchange will take one of the following actions, depending on its policies:

• The exchange may forcibly close your trade before it reaches $900, to cover fees & potential price slippage
• You may be asked to top up your margin account by adding more collateral before the liquidation - this is called a ‘margin call’
• You may lose your collateral money - called a ‘liquidation’
• If this happens to you repeatedly, you may be stopped by the exchange from using leverage in the future

When trading with leverage, you may also experience a downside that doesn’t quite reach your liquidation point - when you trade using leverage, your gains are amplified, as well as your losses, meaning that - when the market goes against your trade, you’ll see your position go into a loss much faster than you would if trading without it.

Traders must also beware of the psychological risks associated with trading leverage. Leverage traders frequently see gains faster than those not using leverage, & as such they may be lulled into a sense of false or overconfidence regarding their trading abilities. This can affect even the highest level of traders - Three Arrows Capital for example, one of the largest hedge funds in crypto, famously went from $18 billion in assets under management to bankruptcy & it is widely believed that an excessive amount of leverage played a contributing role to this.

If you’re set on leverage trading knowing the risks, you could consider starting off with smaller amounts of leverage while learning & use limit-orders to set stop-losses and take-profit orders at certain price points.

Stop-losses are orders that will be triggered when the market moves against your position by a certain amount. The stop-loss will be set at a price limit at which you are comfortable closing out the trade, and will automatically close your position without any manual intervention. They’re a tool commonly used by traders who trade in spot markets too. Setting your stop loss at, or close to a point where you believe the evidence shows your thesis was wrong, is called the invalidation point. Traders commonly set their stop-loss at or around this point, to limit the downside risk from a failed trade.

THE ADVANTAGES OF USING LEVERAGE IN CRYPTO TRADING

The main use case for leverage is enabling traders to trade with larger position sizes. As we’ve seen in the examples above, using leverage means you can make more money while trading with less capital.

Leverage can also help traders conserve their funds if they don’t wish to risk them all.

Let’s use an example to explain this:

If you have $10,000 to trade with and you wish to risk 5% of your funds on a trade, you can use your entire $10,000 to enter the trade and set a stop loss set 5% below your entry. This will ensure that you risk losing a maximum of 5% of your portfolio.

On the other hand, with leverage - assuming you have the same $10,000 and you’d like to risk 5% of your portfolio, you actually don’t need to deploy the full $10,000. You can enter a 20x leveraged trade with $500 of margin and it will trade with the same effect as the full $10,000 from the example above. While you’ll be taking on the additional, general risks of using leverage which we’ve discussed above, you can also set a stop loss to aid with your risk management.

The benefit of this is that you now have an additional $9,500 of funds available to use in other trades - whereas the trader who used their entire $10,000 portfolio can’t do this. This is a common reason for traders to favor leverage over spot trading - freeing up funds to use on more trades.

WHERE TO TRADE USING LEVERAGE

There are different types of products available to traders who wish to trade with leverage. They all involve traders providing an entity with collateral, in order for that entity to lend the trader money with which they can take out positions.

Let’s look at 3 different sources of leverage:

SPOT MARGIN TRADING

First up, trading with spot margin on a centralized exchange.

Spot trading simply means buying & selling the actual assets you’re interested in. For example, you can trade 10 USDC for $10 of Bitcoin and then once you’ve made the trade, you can take the Bitcoin off the exchange & take possession of it.

Spot margin refers to the practice of borrowing money to buy more of a certain asset. Your account might show that you have a negative balance of a specific token when you do this, but don’t worry - as long as your overall account balance remains positive, your position won’t be closed/you won’t be liquidated.

Note: Any funds in your margin wallet may be treated as collateral and sold off (liquidated) if any of your trades are unsuccessful. Traders often prefer to keep their long-term holdings separate from their levered positions, to avoid this.

DERIVATIVES TRADING

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We won’t go into depth about derivatives trading here. There are various different types of derivatives you can use with leverage - futures, perpetuals and options rank among the most popular. Derivatives trading allows you to bet on the price movements of an asset without owning it. Your buy and sell positions are known as long (buy) and short (sell) positions.

Unlike spot trading, where margin is optional - you are required to use margin in derivatives trading & place a collateral deposit to allow you to trade. These are usually offered in the form of coin-margined, or USD-margined – this means you either supply collateral in the form of the underlying asset you’re trading, or in the form of supplied USD.

Frequently in a bull market, traders choose to coin-margin their accounts, as this gives them exposure to a crypto-asset that they might be fundamentally bullish on. However, this also means that it exposes their margin positions to greater risk of liquidations in a down-trend, as the margin will decrease in value at the same time as any long positions a trader may hold.

DECENTRALIZED FINANCE (DEFI)

Leverage can also be used directly through DeFi protocols. Some examples are Aave, Compound, and Euler, which allow you to lend and borrow crypto-assets like BTC and ETH - and either pay or receive interest on those positions.

For example, you could deposit ETH on Aave and borrow stablecoins like USDC or USDT- you can then use these stablecoins in other protocols, to use them to generate yield from other sources.

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For a leveraged long position, you would buy crypto with the borrowed stablecoins & redeposit it. For a leveraged short, you would deposit stablecoins and borrow crypto to exchange for more stablecoins.

These protocols are decentralized and run fully on-chain, which means that they can be accessed by people who are unable or unwilling to access a CEX. Below is a dashboard of various assets that can be supplied or borrowed on Aave, one of the leading DeFi protocols:

WHO IS ALLOWED TO LEVERAGE TRADE?

Whether you can access & use leverage trading products or not depends on many factors, including your jurisdiction’s specific laws and regulations. Rules change quite regularly, so it’s important to stay up to date on your local rules and regulations.

We’d note that some DeFi protocols have been fined or otherwise sanctioned recently - for example, Opyn, ZeroEx and Deridex were collectively fined for $550,000 in September 2023 by the US Commodity Futures Trading Commission (CFTC), for offering unlicensed crypto derivatives products. In 2021, Kraken was also fined by the CFTC for offering margin products to US retail customers without proper registration.

Your exchange of choice may have guidelines as to whether they offer or don’t offer leverage based products for their clients - or you may be able to ask them.