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What is leverage

Unlocking the Power of Leverage in Crypto Trading

Archimedes' lever
"Give me a lever long enough and fulcrum on which to place it, and I shall move the world" – Archimedes

More than two thousand years ago, in the province of Sicily, one of the greatest thinkers that ever lived understood a crucial concept: Leverage, or the art of having a bigger impact with relatively fewer resources at stake.

He may not have realised it at the time, but what Archimedes said of the “mechanical powers” could be applied to all fields of life.

In fact, the concept of leverage has been one of the building blocks of modern civilisation. From labour and capital to code or media, it is, and it has been at the centre of our evolution as humans.

But let’s leave all those philosophical ideas aside for now. Today, we will focus on leverage applied to a specific field: trading.

What is Leverage in Trading?

In crypto trading, leverage is the process of using more funds than you have in your account balance to amplify your trading position. It allows you to control a big position in an asset with a relatively small amount of capital at stake.

In traditional markets, leverage is typically carried out through margin trading (using borrowed funds from a broker to trade a financial asset), but futures contracts (an agreement to buy or sell an asset at a future date for a set price), are also a popular alternative.

While the two are a bit different in their technicalities, they generally work in a similar way:

When you open a leveraged trade, you are required to commit an initial amount of money called the initial margin, serving as collateral to your position. Your account balance must always stay above a certain threshold called the maintenance margin. If the value of your account falls below this level, the broker may issue a margin call, which is required to add additional funds to your account, or else the broker could liquidate the position.

Leverage is as a ratio. For instance, a leverage of 1:10 (10X) implies that you have opened a position worth 10 times the capital you put at stake. So, if you want to open a position worth $5,000 in Ethereum (ETH), a 10X leverage implies that you will only be required to put $500 initially as collateral.  

Some simple examples

Leverage long position

Suppose you want to go long on the ETH-USD pair with a position worth $10,000 and 10x leverage. This means that you will use $1,000 as collateral. Hence, if the ETH price rises by 10%, your position will be worth $11,000 ($10,000 + 10% x $10,000), and you will make $1,000 instead of $100 if you don’t use leverage.

However, if the market drops by 10%, you could face liquidation as your position would be worth $9,000 and lose all your collateral.

Leverage short position

Now, imagine that you want to short Bitcoin (BTC) at a current price of $30,000, with a position worth 1 Bitcoin ($30,000) and a leverage of 30x. This means that the collateral amount you’ll need is $1,000. Now, if bitcoin rises to $31,000, you could face liquidation (remember that you are short, so you incur a loss if the price of bitcoin rises), as you don’t have any more collateral.

Conversely, you will double your investment if bitcoin drops to $29,000.

Benefits and drawbacks of Using Leverage

Benefits

The main benefit of leverage is that it gives you access to larger positions than possible with your funds. Hence, it increases your potential returns.

Further, because leverage amplifies your gains, it allows you to trade smaller moves and still make a decent profit. This makes shorter-term trading more interesting.

Drawbacks

As the saying goes, with great power comes great responsibility. So, while leverage enables higher profit potential, it also puts you in a position where you can incur significant losses on your positions, as the latter is amplified due to the larger-than-usual position.

Leverage can also cause forced liquidation of your position. This means that your position can be closed automatically if your account falls below the maintenance margin. This can cause substantial losses and instantly wipe out your entire collateral amount.

Last but not least, leveraging is more complex as it requires a better understanding of a broad range of risk management tools. These complexities are also a drawback to inexperienced traders.

The Importance of Risk Management

Given the potential danger of leverage, proper risk management is core to your approach if you want to use leverage to trade successfully. Let’s examine some basic risk management measures that could be useful to improve your trading journey:

Risk-to-Reward assessment

Before each trade, you should assess the risk-to-reward ratio. This is a ratio that will help you assess whether a particular trade is worth pursuing by comparing the potential return with the potential risks.

It is calculated as follows:

Risk-to-Reward Ratio (R: R) = Potential Risk (in monetary terms) / Potential Reward (in monetary terms)

Hence, a risk-to-reward ratio (R: R) of 1:3 implies that for every dollar you are ready to risk, you can potentially earn 3 dollars.

As a rule, you should only consider a trade if it has a risk-to-reward ratio greater than 1:1 at the very least.

Risk-to-reward ratio for trades
Risk-to-reward ratio for trades

Appropriate position sizing

You can still lose money even if you enter a trade with a good risk-to-reward ratio. This is why position sizing is also crucial to your trading success. The latter refers to the amount of capital you allocate to a specific trade.

While the good position size varies from trader to trader, it is influenced by several factors, including one’s risk tolerance, account size, or current market volatility.

For instance, one rule of thumb to keep in mind is to never risk more than 1% of your capital on each individual trade. This means that if you are wrong and your exit level (or stop loss) is hit, you will only lose 1% of your equity. This prevents you from incurring large losses that could wipe out your entire account.

Appropriate position sizing
Appropriate position sizing

Let’s imagine you are a really short-term trader and want to go long ETH at a current price of $1800. Based on your analysis, you judge that a stop loss at $1795 is appropriate. Your equity is worth $10,000, and to protect yourself, you only want to risk 1% of your capital on this one trade.

Let’s do a bit of math to calculate the position size: 

Risk  = 1% of 10,000 = $100

This is the amount you are putting at risk. So if your stop loss is hit, you shall only lose this amount. Furthermore:

Risk = Entry Price x Position Size - Stop Loss x Position Size

Risk = (Entry Price - Stop Loss) x Position Size

Position Size = Risk / (Entry Price- Stop Loss)

Position Size = 100 / (1800-1795)

Position Size = 20

Hence, your ideal position size is 20 ETH. At a current price of $1800, this represents a position worth $36,000.

Stop loss

This is where a stop loss can be really useful. A stop loss is a conditional order you place with your broker that will immediately sell your position if the price reaches a specific price level. Its primary purpose is to protect your capital against significant losses when the market moves against you.

Place your stop loss at a level where you consider your trading scenario invalidated. If your stop loss is hit, your position will close automatically, and you will only lose an amount you were ready to lose before the trade.

Further, putting also makes you accept the worst-case scenario of your trade. This helps you remain more emotionally neutral and could lead to better decisions.

Conclusion

Leverage acts as a nuanced tool, subtly enhancing both possible profits and losses. It allows traders to gently amplify their trading positions using borrowed funds, yet it calls for a mindful approach to effective risk management strategies. Traders should take into consideration aspects such as risk-to-reward evaluations, considerate position sizing, and the tactful application of stop loss mechanisms to shield against any unfavourable outcomes, such as account liquidation, that might arise from imprecisely managed leverage. Navigating the path of leverage prudently, with a well-considered risk mitigation strategy, is always advisable.

Key takeaways

  • Leverage is the use of borrowed funds to increase the size of a trading position.
  • The fundamental principle behind leverage is that it amplifies both gains and losses.
  • Effective risk management is crucial if one wishes to use leverage. Some include risk-to-reward assessment, proper position sizing, or the appropriate use of a stop loss.
  • If poorly managed, leverage can lead to liquidation and wipe out your account.

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