As derivatives trading continues to grow, leveraged trading has been a powerful tool for the further acceleration of derivatives trading. Investors are able to maximise returns on small price changes, grow their capital exponentially, and increase their exposure to their desired markets just by using leverage.
However, leverage is a two-edged sword, it can work both for or against an investor. Although investors have a chance at earning huge profits using leverage when asset prices go their way, leverage can amplify losses also if the market swings against the trader using leverage.
Basically, when an investor is trading with leverage, they put a fractional amount down and in return control a much larger trade position in the market. That fractional or “small” amount is what is referred to as a “margin”. The amount of leverage a cryptocurrency exchange offers depends on various factors such as exchange liquidity and regulatory conditions that it has to comply with.
But beyond the regulatory compliance expected of exchanges and the depth of the exchange liquidity to support leveraged trading, traders also use leverage depending on their experience trading financial derivatives, investing goals, risk appetite and the underlying market they are trading. In most cases, it is that they tend to use leverage more aggressively, whereas new and less experienced traders are generally advised to use leverage with caution. Also, conservative traders will tend to use the minimum level of leverage possible, whereas traders with a high appetite for risk can use leverage flexibly.
The type of market traded can also dictate the amount of leverage traders can use. More volatile markets, especially low cap coins should be traded with minimal leverage while the trader can adopt higher leverage levels for less volatile assets that do not post wide price fluctuations.
The leverage ratio is a representation of the position value in relation to the investment amount required. For instance, with a leverage ratio of 400:1; a leveraged trader can control a $100,000 trade position in the market with just $250. The implication is that a 1% positive price change in the market will result in a profit of $1,000 (1% of $100,000). Without leverage, a 1% positive price movement will result in a profit of only $2.5 (1% of $250). This means that such investor’s trade positions and the resulting profits/losses are multiplied 400 times.
What is Margin Trading?
As mentioned earlier, margin is the amount of money a cryptocurrency exchange allows a trader to deposit to have access to trade a much bigger position in the market. As market conditions change, a trader using leverage might have to top up his margin as well in order not to get liquidated. Depending on the particular cryptocurrency exchange, margin conditions are displayed in a trader’s account. Some margin definitions and other terminologies worth knowing are as follows:
This is the total amount available in the trader’s account as they use it as capital for their trading activities.
This is the required amount an investor or trader has to put down as mandated by the cryptocurrency exchange. It is essentially a ‘security deposit’ to control a trade position in the market and it is often expressed as a percentage. E.g. a leverage level of 100:1, your margin requirement is 1%, while leverage of 400:1, comes with a margin requirement of 0.25%.
This is the amount of money held as ‘security’ by your broker so that you can keep your open trade positions running. The money is still theoretically yours, but you can only access it after the open positions are closed.
Is the volume of money in an investor’s trading account available for opening new trade positions in the market.
Cryptocurrency exchange alerts investors that their margin level has fallen below the required level in an event known as a margin call. Margin calls occur when losses of an open trade position exceed (or are about to exceed) your used margin. A trader is expected to top up or add more funds to their trading account to sustain open trades. Automatic closing of positions by the exchange happens if the trader fails to meet up the margin requirement. For instance, a margin call level of 20% means that an exchange will send a margin call notification to a leveraged trader when his open trades have sustained losses of over 80% of his account balance.
Advantages of Leveraged Trading
Leverage affords investors and traders a boost to their capital and an opportunity to open various trading positions in different markets with the extra capital they get from leverage.
Leverage acts as a form of an interest-free loan to traders with no obligation of any expected interest payment or commissions except for margin requirements.
Traders can multiply their profits much more than spot trading with a little capital when markets move in their favour as profits are earned based on trade positions controlled by traders and not margin held.
Traders can make money whether the price of assets increases or dips even with low volatility. As most traders trade market movements, periods of low volatility can be particularly frustrating for traders because of the little price action that occurs. Thankfully, with leveraged trading, traders can potentially bank bigger profits even during these seemingly ‘dull’ moments of low volatility.
Disadvantage of Leverage
Even the slightest market movement can result in amplified losses for leveraged traders. Although leverage may require minimal capital outlay, because trading results are based on the total position size an investor controls, losses can be quite substantial.
Margin call risk represents another major disadvantage of trading leverage. As soon as an investor's margin requirement is about to run low, crypto exchanges may initiate a margin call simply because leverage amplifies losses, there will always be an ever-present ‘margin call’ risk when you have open trading positions in the fast and dynamic financial markets.