The Impact of Leverage in Cryptocurrency Trading

Margin trading is also often used to describe trading with leverage, where margin is the amount of funds that a trader uses as collateral for the leveraged trade.

Like many concepts in crypto trading, leverage and margin trading originated in the traditional financial markets. However, it’s now relatively commonplace for crypto derivatives platforms to offer leverage facilities to traders. These are typically expressed as a margin multiple, so leverage of 20x means the trader can access funds worth up to twenty times the value of their margin.

Brokers and trading platforms will typically ensure that the trader’s account must contain a minimum amount of margin for them to cover the value of any potential losses.

For example, if a trader has open positions and the market moves against them, they may be subject to a margin call. This means that they are required to top up the available margin in their account or close out enough of their traders to bring the margin back to the approved level. Failure to do so will likely result in the exchange or broker liquidating the position to recoup their losses.

Examples of leverage in crypto derivatives

Leverage can be applied slightly differently based on the type of instrument being traded. Typically, leverage is used on cryptocurrency derivatives such as futures and options.

Leverage on cryptocurrency futures or perpetuals

Leverage on cryptocurrency futures or perpetuals contracts works as a straightforward multiplier of a trader’s available collateral. Let’s assume a trader has a starting balance of $1,000 to trade on an exchange offering up to 20x leverage. This gives them a potential trading balance of $20,000 when full leverage is applied.

The current ETH price is $2,000. The trader uses half of their available leverage to buy 5 ETH at a total cost of $10,000. When the price rises to $2,200, the trader sells their entire holding for a total price of $11,000, making a profit of $1,000. This represents a 100% return on the initial investment.

However, if the price of ETH drops, the trader could decide to cut their losses at $1,800 and sell their entire position for $9,000, incurring a loss of $1,000.

In this case, the trader’s starting margin of $1,000 would be sufficient to cover the loss. However, if they’d used the full available leverage multiplier of 20x based on the same starting collateral and ETH price, the rewards and risks start to become more extreme.

With a total trading balance of $20,000, a purchase of 10 ETH with a price increase to $2,200 would net a profit of $2,000. However, the same amount would be lost if the price fell to $1,800 while the trader held an open position of 10 ETH. Now, the trader needs to find another $1,000 to pay their debt to the exchange, as well as lose their starting margin.

Leverage on options

Leverage on options works somewhat differently. Option contracts only cost a small premium relative to the level of market exposure they provide, meaning leverage is inherent to their design and role in the market. Remember that an options contract conveys the right, but not the obligation, to buy or sell a given asset on or before the option expires.

Let’s assume the same ETH price of $2,000 and a bullish trader with access to capital of up to $20,000. They could buy 10 ETH at the spot price, but they can also buy an at-the-money call option with a strike price of $2,000 for just $100 per contract.

If the ETH price goes up to $2,200, then the trader would have made a profit of $2,000 based on a spot purchase. However, the price increase also sees the options contracts' value increase to $300 since traders will pay more for the option to purchase ETH at a below-market rate. Based on a purchase of 10 contracts, the trader could also make a profit of $2,000 but with far higher capital efficiency since the initial outlay is much lower than a spot purchase.

If the price of ETH falls below $2,000 and doesn’t recover before the options expiry, they expire worthless, and the trader loses their $1,000 stake.

Potential benefits and risks of leverage trading

The main benefit of leverage is that it allows a trader to magnify the opportunity for profit using only a relatively small initial payment, making margin trading more capital-efficient. However, the risk of losses is also potentially increased.

While the increased risk of leverage applies to all markets, traders in crypto can be particularly exposed. First, the unregulated nature of crypto markets means that traders can often access very high leverage, which can put more funds at risk.

Second, crypto is more volatile than traditional assets, and markets trade 24/7, so positions can move from profitable to loss-making much quicker, requiring careful monitoring and automation of some activities.

Another factor to consider is the stability of the chosen trading platform. In the event of volatility, high user volumes can create outages or lag times, resulting in being unable to close out positions, introducing even further risk.

Risk management techniques in high-leverage crypto trading

Due to the risks involved in high leverage crypto trading, it’s important for traders to implement an effective risk management strategy that can reduce the chances of a losing trade having a significant impact on profitability.

Traders use various measures to manage risk when crypto margin trading. Planning the trade is an important step before opening a position, so the trader should define the amount of leverage and their chosen entry and exit points for both taking profit and cutting a loss.

Position size is also a critical consideration. Some traders stick to a rule of only trading one or a few percent of their total capital to avoid any risk of a wipeout in one losing transaction.

Once the position is open, using automated tools like stop-loss and take-profit orders will ensure that the trade is closed according to the plan whenever the market reaches the defined price. This eliminates any risk of the trade continuing to lose money while the trader isn’t monitoring the open position.

Finally, traders should make sure they understand the terms of their trading account and what happens in the event of a margin call. For example, cross-margin accounts enable traders to use all available capital for any trade, but, similarly, the capital can then be recovered to fill any margin call.

Isolated margin accounts can be more cumbersome to manage since they require posting collateral in each traded asset (I.e., A BTC trade requires collateral in BTC, an ETH trade in ETH, etc.), but this can offer protection in the event of a loss resulting in a margin call since the margin can’t necessarily be taken from other accounts.

Leverage in cryptocurrency trading essentials

• Leverage trading enables traders to borrow funds or use options contracts to magnify the opportunity for returns relative to outlay.
• While leverage in crypto trading provides opportunities for capital efficiency and greater profits, it can also exponentially increase risk – particularly in the volatile crypto markets.
• Crypto margin trading should be carried out using a set of risk management measures to offset the chances of generating large losses.