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Lesson 5
3 min

What is leveraged trading?

An introduction as to what leveraged trading is, and how the process of borrowing funds to amplify potential returns, or losses in some cases, can enable traders to gain larger positions with smaller capital in

Key Points:

  • Leveraged trading in cryptocurrency markets involves borrowing funds to increase the potential returns on an investment.
  • Also known as margin trading, this method enables traders to amplify their exposure to financial assets by borrowing funds from a broker or exchange. This allows them to control a larger position size with a smaller amount of capital.
  • Though leveraged trading can offer the potential for higher profits, it also increases the risks involved, such as liquidation risk, price volatility, margin calls, and the loss of invested capital.

What is leveraged trading?

Leveraged trading in cryptocurrency markets involves borrowing funds to amplify the potential returns on an investment. Traders can enter positions larger than their initial capital, known as trading on margin, by using leverage provided by exchanges or trading platforms. While leveraged trading offers the potential for higher profits, it also significantly increases the risks involved. Common risks include liquidation risk, price volatility, margin calls, and the potential loss of the entire invested capital. Traders should exercise caution and implement risk management strategies to mitigate these risks effectively.

How Leveraged Trading Works

Leverage Ratio:

Leverage is expressed as a ratio, such as 2x, 10x, 100x or more, indicating the amount of borrowed funds relative to the trader's initial capital. For example with 2x (2:1) leverage, a trader can control a position twice the size of their initial capital. So, if a trader wanted to control 1 Bitcoin, and Bitcoin was trading at $70,000, a position with 2x leverage would require only $35,000 to open. 

Margin Requirements:

To enter a leveraged position, traders are required to deposit a certain percentage of the total position size as collateral, known as margin. The remaining funds are borrowed from the exchange or broker (In reality they aren't borrowed but balanced against the exchange holdings).

Potential Returns and Losses:

Leveraged trading amplifies both potential returns and losses. While traders can potentially magnify their profits by leveraging their positions, they also risk losing all of their initial capital if the trade goes against them.

Risks of Leveraged Trading in Cryptocurrency Markets

Liquidation Risk:

One of the primary risks of leveraged trading is liquidation risk, where a trader's position is automatically closed by the exchange or broker to prevent further losses. Liquidation occurs when the value of the trader's position falls below the required margin level. In volatile cryptocurrency markets, price fluctuations can lead to rapid and unexpected liquidations, resulting in significant losses for traders. 

For example, let’s say you buy $1000 worth of Bitcoin with 5x leverage, meaning you control a position worth $5000. In the case of a market decline, the value of your position will increase at a faster rate. If the margin falls below a certain threshold, where your original position is no longer able to cover the potential losses, the exchange will liquidate your entire position - hence liquidation. 

Price Volatility:

Cryptocurrency markets are known for their high volatility, with prices capable of experiencing large fluctuations in short periods. While volatility presents opportunities for profit in leveraged trading, it also increases the likelihood of losses, especially when using high levels of leverage.

Margin Calls: 

Margin calls occur when the value of a trader's position falls below the maintenance margin level set by the exchange or broker. Traders are required to deposit additional funds to meet margin requirements, or their positions may be liquidated. Margin calls can lead to forced liquidations and substantial losses if traders are unable to meet the margin requirements.

Total Loss of Capital:

In leveraged trading, traders risk magnified loses, and can lose all of their initial capital 

Mitigating Risks in Leveraged Trading:

With leveraged trading, the potential for substantial gains is matched by the inherent risks. This is why, where possible, mitigating these risks is paramount. In understanding that leveraged trading involves amplifying positions with borrowed funds, magnifying both profits and losses, having a prudent approach to risk management can help to safeguard against catastrophic outcomes. A few of these strategies are outlined below.

Risk Management Strategies: 

Traders should implement risk management strategies, such as setting stop-loss orders and position size limits. Stop-loss orders automatically close positions at predetermined price levels to limit losses, while position size limits set an upper bound on the funds at risk. 

Understanding Leverage: 

Traders should have a thorough understanding of leverage and its implications before engaging in leveraged trading. Using excessive leverage can magnify losses and increase the likelihood of liquidation.

Staying Informed: 

Cryptocurrency markets are highly volatile and influenced by various factors such as news events, regulatory developments, and market sentiment. Traders should stay informed about market trends and developments to make informed trading decisions.

Please note that statistics have shown that over 79% of traders in cryptocurrency markets lose money on leveraged trades as they consistently underestimate volatility and risk. Many of the so-called wicks in charts (rapid big declines followed by quick recovery) are caused by leveraged trading as positions get liquidated. When buying a spot, this has only a temporary effect on your balance. When using leverage, liquidation means you have no more funds to trade with. 

 

Lesson 25: A roundup

  • Leveraged trading in cryptocurrency markets involves borrowing funds to amplify potential returns on an investment.
  • While leveraged trading offers the potential for higher profits, it also significantly increases the risks involved, including liquidation risk, price volatility, margin calls, and the potential loss of the entire invested capital.
  • Traders should exercise caution and implement risk management strategies to mitigate these risks effectively. This includes setting stop-loss orders, understanding leverage, and staying informed about market trends and developments.
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