Derivatives are financial tools whose capacity for magnifying gains and losses is rooted in the concept of leverage. In cryptocurrency markets, derivatives give traders the opportunity to make outsized profits in digital asset trading—at the cost of increased risk.
Definitions of margin and leverage
In physics, a lever describes a simple machine that uses a straight component and a hinge to aid a small force in exerting a larger effect. Think of a bottle opener, where a minimal force at an appropriate angle can exert the pressure needed to pop off a tightly applied cap.
In finance, leverage is a similar concept. Leveraged trading offers traders the ability to control large sums of assets while only holding a small percentage of the value of those assets. But the “large sums” must come from somewhere. To trade with non-held assets, traders effectively borrow these funds from a broker or—in the case of decentralized finance (DeFi) protocols—from a pool of other users/traders.
The parties that assume the risk of lending assets to leveraged traders (called “counterparties”) must assure they do not lose too much money on traders’ bets, or else their own risk is too high. In order to defray their risk, they require traders to post collateral in the form or margin. Margin is generally expressed as a percentage of leveraged positions, and if the trader does not meet the margin requirements, the counterparty—usually a broker, exchange, or smart contract platform—can exercise the right to take control of the traders’ assets and sell them.
How leverage works in trading
There are a few ways to trade with leverage in cryptocurrency markets. The most common way is through futures or options trading through centralized exchanges and brokers. These platforms act as counterparties, and they offer trading of derivatives like traditional brokers in the stock and bond markets. Using smart contract-enabled blockchains like Ethereum, DeFi protocols like dYdX offer derivatives called perpetual futures/swaps and mediate the interchange between leveraged traders and pooled counterparties.
When making a leveraged trade, especially using perpetual products, users will most often see leverage expressed as a multiple or a ratio. For instance, a trade with 10x leverage requires one-tenth the collateral (margin) to control the full amount of funds. In other words, there is a 10:1 ratio of a trade’s value to the required margin.
If a trader makes a “long” 10x leveraged trade using $1000 of held funds to buy ETH, they effectively buy $10,000 worth of ETH. If the price of ETH then increases by 5% while the trader holds the trade, they make a profit of 5% of $10,000 = $500, rather than $50 if they had only invested $1000 without leverage. However, their potential losses are magnified in the same way.
Margin requirements and maintenance
On its most basic level, margin is simply collateral. It is the guarantee a trader makes to their counterparty that they will be “good” for the assets they borrow. There is often an initial margin which is required to make leveraged trades, and a maintenance margin threshold that must be sustained as trades increase and decrease in value. If the value of the trader’s account falls below the threshold, their broker can issue a margin call, which requires a deposit of further funds—or a selling of assets—to align the account with margin requirements.
To make the process more easily understandable, modern derivatives platforms may display a “liquidation price.” This takes the guesswork out of maintaining margin requirements calculated by a percentage of positions. Instead, when a trader enters a leveraged trade, the platform calculates at what price the risk of loss is excessive, presents that price level to the trader, and it reclaims and/or sells the trader’s collateral (or “liquidates” them) if the underlying asset falls below that level rather than issuing a margin call.
For instance, if a trader buys BTC with 5x leverage and the “liquidation level” is at $55,000, they can stay in the trade unless BTC falls below that valuation. If that occurs, the platform can liquidate the trader and sell all their assets made in that trade. While this gives traders some transparency about price thresholds, the nature of its automation presents its own risks.
Risks of leveraged trading
There are several risks associated with leveraged trading that traders must be aware of:
Lack of understanding about how leverage/margin works. Traders should be educated on the general concepts of leverage and margin before entering any leveraged trades or using any derivative products.
Magnified losses. The amplification of profits and losses is as much a feature of leveraged trading as it is a risk. After all, this is the point of leverage. However, while many traders believe they have an edge or can “beat the market” with strategies like technical analysis, the truth is that predicting swings in price is difficult, and losses occur approximately as often as gains. When those losses are inflated by leverage, they can mount.
Regulation. Traders should ensure that they aware of the national and local laws surrounding leveraged trading of crypto products that applies to them. Some Countries expressly prohibited certain types of traders and forms of trading.