Leverage trading: What, Why, How?
|— In leverage trading, you are basically borrowing money from the exchange and making a bigger wager than what you traditionally could with your own money – i.e. you can make a $1000 wager with just $100.|
— Although having high upside potential, leveraged trading is one of the riskiest forms of trading crypto because it requires a lot of education before safely navigating it.
— Because the crypto market is highly volatile the risk of leverage trading is even higher than with other assets like stocks
Making your first steps in crypto land and looking to use leverage trading? Then this might be the perfect thing for you.
“To leverage or not to leverage?” In a crypto-world where volatility is ever-present, taking risks can yield rewards but it can also prove to be fatal. One of the biggest risks in crypto-trading is using leverage, especially when you’re not well versed in the topic. “
What exactly is leverage? Why is leverage risky? How should you use it?” These are all great questions we will be covering below so that you don’t take any unnecessary risks.
Leverage, you said?
With leverage, you are basically borrowing money from the broker to make a better investment deal with your money. Say you want to buy 1000$ worth of Bitcoin but you don’t have the money. You can use a “10 to 1” leverage rate and get that $1000 worth of BTC with just $100, which is that 10th part of the deal or, the so-called “margin” in trading.
What happens now?
You now have $1000 worth of BTC on your exchange account and you’re basically on top of a wild horse called “leveraged trading”. The purpose of leverage is not to hold on to your position but to take advantage of the up-and-down swings that the market has.
Say you bet your freshly borrowed $1000 on BTC going up otherwise known as “longing” and Bitcoin goes up 20%. You have now earned $200.
But what happens if the price of BTC drops 20%? You might have guessed it right off the bat – you’re going to be down $200 (remember you only had $100 to begin with). This means that whatever credit you have in your account will be used to cover up for that loss!
In other scary words, you’ll be liquidated.
To long or to short
We mentioned “longing” and “shorting” previously. What exactly are they and how do they relate to leverage?
Longing is basically betting on the fact that an asset is going up whereas shorting is the complete opposite, you bet that asset is going down. So longing is basically buying an asset and waiting for it to grow in order to reap the profits. Shorting, on the other hand, means selling off an asset, waiting for the price to drop and then buying that asset again at a lower cost.
Doing this with leverage, actually means utilizing these tactics with borrowed funds. Although the allure of a great reward is high on a leveraged trade, you run a high risk of being liquidated if the market moves against you.
Why is leverage risky?
1. Getting Liquidated
What is liquidation you may ask?
Well, liquidation occurs when the exchange forcefully closes your trading position because your leveraged trade failed due to the deviation.
Given the wide gaps between market swings, leveraging with a high-margin in crypto is borderline suicidal. For instance a 100:1 leverage would only require a 1% deviation for your trade to get liquidated.
This deviation occurs when the price of a crypto asset moves away from your intended trade objective. With our example of a 100:1 leverage, you risk losing everything you have if the price goes just 1% in the direction opposite of your wager.
2. Getting REKT because of volatility
The first thing that you might have noticed is that using leverage in a volatile market, will potentially lead to unpleasant results if one is not experienced enough. The greatest risk you run when playing with leveraged trading is getting REKT.
Depending on the exchange, each broker will enforce a certain “safety deposit”, based on the amount you are investing and want to borrow from the broker. For example, Binance, will allow its users to use their crypto assets as collateral when working with leveraged/margin trading.
If your trade goes bad, Binance will use the collateral in your account to cover up for your losses. The main point of the lesson is that using leverage requires a lot of experience. It gets even more risky when you’re playing with the fire of high margins, like 50:1, 100:1.
3. Uneducated wagers are the ones at risk
If we look at the stats, we can see a clear trend. Most of the failed leverage trades occur with inexperienced traders. If you’re new to crypto and to trading DO NOT attempt to use leverage. You run the highest risk of getting REKT!
In order to properly work with a risky instrument such as leverage, one needs an intimate understanding of the mechanics and market dynamics.
If you’re looking to get into leverage trading, we recommend you start with a healthy dose of trading education. Only after going through some serious educational material and having worked with some demo accounts, should you consider leverage trading.
How to work with leverage trading?
1. Learn, learn and never stop learning
Leverage is a highly risky, advanced feature of trading. Regardless if you’re trading crypto, stocks, commodities, gold, forex and what not, you should be highly informed before dipping your toes in.
Taking a few courses from knowledgeable traders, actively watching several series of YouTube videos and soaking up as much information as possible will be the basis of your leverage trading education.
2. Practice before committing
Some exchanges offer the possibility of working with “paper money”. What’s that?
“Paper money” is basically “play money” or “Monopoly money”. You’ll have a separate account where you can use your play money and start experimenting with 0 risk. You will have access to the same features like in the live exchange but you won’t be risking your money.
Practice until you feel confident enough before starting to make live wagers with your own funds.
3. Don’t go ALL IN
When starting to wager your own money, NEVER go for more than you can afford to lose. Since the crypto market has great swings, it’s advisable never to work with high margins.
Only after you have mastered working with paper money and small margins should you commit to using real funds with larger margins.
If you snooze, you lose! This can very well be the motto for leverage trading. Even if this kind of trading looks attractive to beginners and can spell big wins, it’s also a pitfall that can spell WRECKAGE for those that haven’t done their homework.
Our advice – don’t work with something risky without wrapping your head around it, if you decide to do so, take all the necessary precautions and DYOR. This is not financial advice.
Knowledge is power.
Keep on learning! If you enjoy getting to grips with crypto and blockchain, check out our School of Block video.