In the world of crypto and spot trading, leverage is considered a quick way to dramatically increase your trading profits. Leverage allows traders to make more money with borrowed funds while trading than they could with their own small capital. In this way, the leverage effect contributes to the amplification of the buying and selling power of the traders. Although it increases profits, the risks it poses to crypto beginners make it a double-edged sword.
What is Leverage in Cryptocurrency?
The leverage effect, in the field of cryptocurrency trading, refers to the use of loaned capital to exchange cryptocurrencies, stocks or other assets. Leverage is used by traders or investors to increase the capital they have so that they have more funds to trade.
The amount of leverage is usually represented by a "leverage ratio", for example 1:5 (🗙5), 1:10 (🗙10) or 1:20 (🗙20). For example, the ratio 1:5 or the leverage 🗙5 shows that the initial capital in the trader's portfolio will be multiplied by 5 and thus increase an amount from $100 to $500.
Leverage is provided by the broker or crypto exchange the trader is using. Also, depending on the exchange used by traders, the amount of leverage can vary from 1:1 to 1:500, or even more in some cases. As an example, on HitBTC, traders could borrow money up to 100 times their actual wallet balance.
Leverage ratios for different token pairs also differ within the same exchange. HitBTC, for example, offers 🗙10 leverage on BTC/USD while only giving 🗙5 for the SOL/ETH pair.
How does crypto leverage trading work?
The first step a trader must take before using leverage is to add funds to their crypto exchange account as “collateral”. The amount of collateral required (or margin) depends on the leverage, the type of cryptocurrency, and the total value of the position the trader or investor wishes to open.
Using the amount of leverage and the margin, it is quite simple to calculate the collateral that needs to be added to the trading account. To open a $1,000 Ethereum position with a leverage of 🗙10, for example, the collateral required would be 1/10 of $1,000 = $100. This means that the trader must deposit $100 margin for the borrowed funds.
It should be noted that increasing the amount of leverage decreases the required margin - leverage of 1/20 to open the same position worth $1,000 drops the collateral to $50. However, with higher amounts of leverage comes the danger of greater liquidation.
Apart from depositing the initial margin, the trader must maintain a guarantee threshold amount on the account, also called maintenance margin. In cases where the crypto market tide is moving against the trader's position, the collateral amount may fall below the threshold. This scenario forces the trader to deposit more funds in order to maintain the marginal threshold condition to avoid liquidation.
Benefits and Risks of Using Leverage in Cryptocurrency
One of the main advantages of using leverage is the potential for rapidly increasing trading profits, even with small capital. Another reason to use leverage is that it helps in the liquidation of funds. This allows traders to use their limited capital to explore other aspects of crypto like trading, staking, or even investing in cryptocurrencies.
Although the option of higher leverage requiring only a small margin is quite attractive, it increases the possibility of liquidation and decreases the volatility tolerance of the funds. If the leverage is too high, even a 1% fluctuation can result in significant losses.