15th Dec 2020

Understanding Leverage When Trading Cryptocurrencies

Article Table of Contents:

What is Leverage?
How to Trade with Leverage?
Leverage vs Margin Trading

Gears are one of the greatest mechanical inventions. This is what allows the magnification of speed and power of a vehicle. These simple machines lie at the heart of some of the most important applications todays, including clocks, power plants and even aircraft. Leverage fulfills a similar role in trading.
In cryptocurrency trading, leverage allows traders to get a much larger exposure to the market. This, in turn, can help magnify trading opportunities. But the losses are also multiplied, in case the market moves in the wrong direction. In essence, in leveraged trading, the investor borrows capital from the broker. This helps them enter into a position that is larger than what could be afforded with the funds in the trading account alone. 

The term “leverage” denotes the degree to which the position is increased. For instance, with 10x leverage, a $500 Bitcoin position can be raised to a $5,000 one. This means you would be putting in just $500, while the remaining $4,500 would be lent to you by the broker. It puts you in a position to take better advantage of the volatile crypto market.

Leverage is not unique to crypto trading though. It is used quite commonly in many financial areas, including mortgage. A mortgage is similar to leverage in trading. If you buy a home with $10,000 of your money and a $40,000 loan, it is similar to a 5x leverage. 

This size of leverage would usually be expressed as 1:5 in the trading world. In crypto trading, leverage can go up to 1:500.

A Weakening US Dollar

When trading with leverage, picking the right leverage ratio is vital. The ratio depends on your level of experience, trading goals and the risk to reward ratio. If you are just starting out with leveraged trading, it is best to keep the leverage level low. Beginner traders prefer not to risk more than 1% to 2% of their trading capital on a single position.

As you gain experience with trading cryptos, the leverage ratio can be increased. Also, make sure to use appropriate risk management tools, such as stop loss, take profit and trailing stops, to limit downside risk.

Leverage vs Margin Trading

Leverage and margin trading are terms used interchangeably at times. This could lead to confusion. As mentioned earlier, leverage is the amount provided by the broker to a trader. It is generally expressed in ratios such as 1:X. Here, X represents the number of times over that the broker matches the investment of the trader.

But to start trading cryptos, traders need to open a margin account with a broker. A minimum amount of funds needs to then be deposited in the trading account before a leveraged position can be offered by the broker. This margin is generally expressed in terms of percentages, such as 2.5%, 4%, or 5%. For instance, you have taken a position worth $100,000 with a $1,000 payment. This means that the leverage is 1:100. The margin percentage in this case would be 1%.

The deposit margin or initial margin is the minimum amount required for opening an account. In case any losses are incurred, the funds will be deducted from the trading account. In case the funds fall below the minimum margin required by the broker to keep a position open, a warning will be issued to the trader. This is known as a “margin call” and is issued so that the trader can deposit the necessary amount. If the amount is not deposited, all the positions will get closed. So, the margin can also be thought of as a security deposit.

If managed properly, leverage can help achieve long term trading success. But it also can lead to large losses. Therefore, having a robust trading plan with proper risk management tools is vital. Also, it is best to not risk more than you can afford to lose on any one position.
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