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Saturday, December 2, 2023

What is Leverage in Cryptocurrency Trading?

Unlock the secrets of leverage in cryptocurrency trading. Learn how to magnify your trades using borrowed funds and manage risks with limit orders. A concise guide for traders to navigate the volatile crypto market with confidence.

Leverage in cryptocurrency trading refers to the use of borrowed capital to trade on cryptocurrency exchanges. Leveraged trading empowers traders by providing them with additional capital, but also imposes additional self-discipline requirements. So, leverage can be a powerful tool in cryptocurrency trading, enabling traders to seize opportunities and potentially amplify returns. However, it is crucial to exercise caution and implement sound risk management practices to navigate the volatile nature of the crypto market successfully.

For those who don’t feel comfortable about the unknown and/or hard-to-calculate risks, it would be worth knowing, that some crypto exchanges have introduced interesting alternative “mass products” in the form of crypto exchange funds. If a trader does not have a stable internet connection, in case of his assets’ significant price movements to make the occasionally occurring deficit of collateral — often referred to as facing a threat of a margin call (more details below) — in such a situation it would be much safer and wiser to buy such a “one-size-fits-all” fund, which already includes leverage, and in this case the responsibility of its provision and adequacy is assumed by the professional managers.

Leverage Trading: Main Idea and Definitions

When trading with leverage, even a small amount of initial capital can be used as collateral. This allows a trader to increase his/her profit potential in exchange for an increased level of risk. Some cryptocurrency exchanges allow you to leverage up to 100 times the outstanding balance. That multiplier cannot be found anywhere else when trading other types of assets, such as currencies or stocks.

The amount of leverage is expressed as a ratio, such as 1:5 (5X), 1:10 (10X), or 1:20 (20X), which indicates how many times a trader can grow his/her initial funds. For example, suppose a trader has $100 in the stock market but wants to take a position in Bitcoin (BTC) for $1,000. By using 10X leverage, $100 turns into $1,000 (more below).

Leverage can also be used to trade various cryptocurrency derivatives (typically futures or non-expiring futures). Common types of leveraged trading include margin trading, leveraged token trading, and futures contracts.

One can borrow funds from the exchange and start trading using leverage only after depositing funds into the trading account. The initially deposited funds are called collateral or security. The amount of collateral required depends on the leverage used and the total amount a trader intends to open a position for (called ‘margin’).

For example, suppose a trader invests $1,000 in Ethereum (ETH) with a leverage of 10X. The margin requirement is 1/10th of $1000, meaning he/she needs to have $100 in his/her account as collateral for the borrowed funds. With 20X leverage, the margin requirement is even lower (1/20th of $1000 = $50). However, it should be remembered that the higher the leverage, the higher the risk of forced liquidation of the trading position with a partial or even full loss of the initial deposit.

Leverage in Cryptocurrency Trading: Examples

Cryptocurrency trading has gained immense popularity in recent years, offering investors an opportunity to capitalize on the volatile nature of digital assets. One key aspect that traders often utilize to maximize their potential gains is leverage. Leverage enables traders to amplify their exposure to the market, allowing them to control larger positions with a smaller amount of capital. While it may greatly enhance profits, leverage also carries an inherent risk of magnifying losses. Here, we will explore a few examples of how leverage can be employed in cryptocurrency trading.

Firstly, let’s consider the scenario where a trader wants to open a position in Bitcoin. With a leverage ratio of 10:1, the trader can control 10X the amount of Bitcoin with the same initial investment. If the price of Bitcoin increases by 5%, the trader's profits would be amplified by a factor of ten. However, in the event of a 5% decline, losses would also be multiplied by ten.

Another example can be observed when trading altcoins. Let's say a trader has a bullish outlook on Ethereum, but has limited capital. By using leverage, the trader can control a larger Ethereum position, potentially increasing profits if the price appreciates. Conversely, if the price declines, losses can also be amplified.

Once again, it is crucial to understand that leverage — especially, maximum permitted leverage — should be used cautiously, as the crypto market's volatility can lead to rapid and substantial losses. Proper risk management strategies, such as setting stop-loss orders and avoiding excessive leverage ratios, are paramount to ensure the sustainability of trading activities.

In addition to the initial margin deposit, traders must maintain the necessary margin threshold for trading. If the market moves against the expected direction, causing the margin to fall below the minimum threshold, then as with all investment instruments and in accordance with the popular Hollywood movie “Margin Call”, a trader will have to add funds by raising the minimum margin to avoid liquidation. This threshold is also known as the maintenance margin.

Leverage can be used to create long and short positions. The purpose of a long position is to increase the price of an asset. On the other hand, a short position is created with the objective of decreasing the price of an asset. While this is similar to normal spot trading, leverage allows a trader to buy or sell an asset based on collateral rather than on available funds. This means that even if a trader doesn't own the asset, he/she can borrow it and sell it (create a short position) if its price is expected to fall.

Leveraged trading can seem very complicated — especially for beginners. It is very important to understand the principles of leverage before trying to use real money.

Why to Leverage the Cryptocurrency Trading and How to Manage Risk of Leveraged Trading

As mentioned above, traders use leverage to increase the size of their positions and increase their profit potential. However, as we also mentioned above, leveraged trading can simultaneously lead to considerable losses if used mindlessly.

Another reason for using leverage is to increase the liquidity of capital. For example, a 2X leveraged position on one exchange can be leveraged 4X to maintain the same position size with less collateral. This allows some capital to be used elsewhere (e.g., trading another asset, betting, providing decentralized exchange (DEX) liquidity, or investing in NFTs).

If leverage is too high, even a 1% fluctuation in price can result in significant losses. The higher the leverage, the lower the so-called tolerance to volatility. Using low leverage is an opportunity to protect him- or herself from serious losses due to trading errors or simply an episode of broken internet connection, so the most reputable cryptocurrency exchanges unequivocally limit the maximum leverage for new — and sometimes even experienced — traders.

Risk management strategies such as stop loss and take profit help to minimize losses when trading with leverage. Stop loss orders can be used to automatically close a position at a certain price and/or timestamp, which is useful if the market moves against a trader or a trader doesn’t want to carry forward his risks onto the next date. Stop loss orders help prevent serious losses. Profit orders (so-called take profit orders) do the opposite: they automatically close the position when the profit reaches a certain value, allowing a trader to keep the profit until the market situation changes.

It is clear from the above that leveraged trading is an ambiguous method of increasing both losses and profits. It involves a high level of risk, especially in a volatile cryptocurrency market, which is why Binance, ByBit, and most other legitimate crypto exchanges encourage traders to trade consciously and take responsibility for their actions. To better control trading, in addition to the aforementioned crypto exchange margin funds, they offer tools such as critical price level alerts and lockout periods. It is always important to remember to be meticulous, use leverage properly, and make a trader’s own calculations to plan his/her trading strategy in the most effective way.

Leveraged Crypto Trading Bots

Leveraged crypto trading bots can be a particularly powerful tool for cryptocurrency traders looking not only to maximize their potential profits, but also apply various self-adjustable or even AI-powered automated trading strategies. 

Leveraged trading bots are designed to automatically execute trades based on predefined strategies and market conditions. They can automatically and very efficiently analyze real-time market data, as well as monitor multiple cryptocurrency exchanges, and execute trades quickly and optimally.

Unsurprisingly, crypto trading bots have become an effective tool for navigating the crypto market. Essentially, crypto bots are advanced script-based programs sending relevant signals to the trading platform whenever a given situation occurs, or a certain technically established price level is reached while constantly analyzing multiple parameters.

How does a trading bot work? The bot connects to cryptocurrency exchanges via application processing interfaces (APIs) and uses advanced algorithmic methods to derive the best conditions for entry or exit points in trades. Below is the list of the main advantages of using crypto autobots:

  1. Automation – this feature pretty much speaks for itself. By studying, backtesting, and analyzing market prices, relevant charts, and various input signals, crypto bots ensure a certain level of trading success. Beginners can also set up a crypto bot to automate trading while learning the industry.
  2. Mirror Trading – the bot follows the trading patterns of successful traders – their strategies, signals, and templates, and further applies them to the trades.
  3. Execution – the bot takes into account a variety of factors and executes trades much faster than humans. A beginner can set his basic trading parameters and the crypto robot will execute trades under these conditions.
  4. Passive Income – normally, crypto bots can run 24/7 without the need for constant monitoring and providing feedback to their owner. Any beginner can take advantage of advanced algorithms and create a passive income stream in the cryptocurrency market.
  5. Demo Trading – in this case, well-known cryptocurrency trading bots allow beginners (and not only!) to practice demo trading learning behavior and breadth of the market without actually owning the cryptocurrency and, hence, incurring material risk. This process allows novice traders to learn the basics of cryptocurrency trading in a low-risk environment.

Trading bots are also a popular tool for experienced traders. Let’s take a look at the benefits of using bots for cryptocurrency trading, from advanced testing to automated manual trading.

  1. Backtesting Strategies – the bot incorporating this feature allows an experienced trader to test his trading strategies based on past historical data. Traders can evaluate how their current trading strategy compares to previous market conditions. This allows individuals to increase the probability of success of their current strategy.
  2. Multiple Trades – even experienced traders cannot execute multiple trades at the same time. Cryptocurrency bots allow traders to set manual parameters and conditions to enter or exit specific digital currencies. Once the conditions set by the trader are met, the robot automatically executes the trade, enabling multiple trades.
  3. Elimination of Emotional Decisions – even the most experienced traders can fall into greedy buying and panic selling. Crypto bots remove subjective emotions from the equation and conduct objective trades based on mathematical algorithms. In addition, it offers experienced traders the opportunity to buy specific coins under ideal conditions without taking into account time, fatigue, and emotions.
  4. Capitalizing on Volatility – the cryptocurrency industry continues to experience extreme volatility. It is common for prices to suddenly rise or fall. With the help of bots, experienced traders can take advantage of this volatility through long or short positions and make profits even during downtrends.
  5. Advanced Strategies – experienced traders can take advantage of mirror trading and arbitrage trading within the exchange, and gain intelligence through bots that process gigabytes of data in seconds, while taking advantage of the bot’s trading indicators and efficient execution.

We should always remember, that trading bots are tools that can assist in and soften the trading intricacies, but they should not be solely relied upon for making trading decisions. It's essential to have a good understanding of the cryptocurrency market and develop one’s own trading strategies.

Made by 0xDEFCAFE, 2023