Cryptocurrency technology and trading have come a long way since Bitcoin’s inception over a decade ago. Bitcoin’s rise to $20,000 in December of 2017 caught the eye of many investors looking to profit by trading the digital asset. Trading cryptocurrencies is not a new concept; investors typically buy or sell a cryptocurrency to make a profit down the line. However, if done right, leverage trading opens the door for traders to make even more substantial gains than trading the already volatile cryptomarkets.
What is leverage trading?
Leverage trading, often referred to as margin trading, allows traders to borrow funds, reducing their initial contribution to the position. In theory, this enables traders to amplify their returns by trading with larger positions than they would’ve been able to without leverage. That being said, leverage trading comes with far more significant risks than traditional trading, but we will get into that later.
How does it work?
Traders can use leverage to open both long and short positions, allowing them to make a profit and bet on a cryptocurrency’s price going in either direction.
Opening Bitcoin Longs
In concept, leverage trading is quite simple. For example, with a 5x leverage, a $1,000 Bitcoin position only requires $200 of the trader’s funds while the other $800 is borrowed. Now suppose Bitcoin rises 10%, and the trader decides to close the position at $1,100. The trader will then pay back the $800 plus fees and end up with approximately $300. Without factoring in fees, the trader effectively realized a 50% gain on their initial $200 investment. In other words, with 5x leverage, traders can make approximately five times the returns than if they did not use leverage.
However, leverage trading can be even more lucrative for traders willing to undertake more risk. For example, traders trading with a 100x leverage realize gains of approximately 100 times more than if they did not use leverage. To put this into perspective, with 100x leverage, a $25,000 position will only require $250 in funding. Closing the position 10% higher will make the trader $2250 on a $250 contribution, without factoring in fees. However, the risk of liquidation increases as traders opt for larger leverage, a topic which we will dive deeper into later.
Opening Bitcoin Shorts
Traders can also use leverage to open short positions. For example, with a 5x leverage, a trader will fund a one Bitcoin short position with 0.20 Bitcoin while borrowing the other 0.80 Bitcoin. Suppose Bitcoin’s price is $10,000 when the position is opened. The trader will then sell the Bitcoin for $10,000. Assuming Bitcoin falls and the trader decides to close the position at $9,000, the trader will then purchase a Bitcoin for $9,000 and pay back the borrowed 0.80 Bitcoin profiting $1,000 without factoring in fees. Through leverage, the trader once again was able to amplify returns.
Why leverage trading is not for everyone
While leverage can increase a trader’s trading power, leverage trading comes with its inherent risks. Trading using leverage also amplifies losses at the same rate it amplifies gains.
For example, a trader opening a $1,000 Bitcoin long with 10x leverage will fund the position at $100 and borrow $900. If Bitcoin goes in the opposite direction, falling 5%, the entire position will now be worth $950. If the trader decides to cut their losses, the 5% loss is amplified 10x, meaning the trader lost 50% of their initial contribution ($50). Furthermore, the situation can get worse if Bitcoin falls 10%. With a 10x leverage, a fall of 10% will trigger a liquidation. A 10% fall will mean the entire position is worth $900. Since the trader borrowed $900, the position will automatically be closed with the $900 being paid back, and the trader is left with nothing.
Furthermore, liquidations are not uncommon. Even relatively minor Bitcoin price movements can trigger a wave of long liquidations. A few weeks prior, over $30 million in Bitcoin longs were liquidated in a 24-hour timeframe, despite Bitcoin’s price only being down 2%.
Therefore, while trading with leverage can be highly lucrative, it is also highly risky. While traders can trade using lower leverage, they are still not immune from risk. For example, Bitcoin fell from over $7,000 to the low $4,000s within 24 hours on March 12, 2020, an event later dubbed as “Black Thursday.” With Black Thursday reinforcing the risks of leverage trading, traders deciding to utilize leverage must be adept at risk management and understand the far higher risk they are undertaking.
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