What is leverage?

Intermediate
March 27, 2023
Read time:
6m

Leverage in cryptocurrencies allows you to trade cryptocurrencies using borrowed capital, making it possible to compound potential profits and losses.


It’s designed for advanced traders, as you need a great deal of investment experience, an understanding of the involved risk, and the use of leverage according to your financial abilities to exploit its potential.

Example: a trader wants to open a position that exceeds the current value of his portfolio.

By investing $1,000 and using 5x leverage, he can open a position worth $5,000. This opens the way for a larger profit, but an equally proportionate loss.


When using leverage, you should carefully determine the level of leverage based on your own financial ability. You should not use leverage at a higher level than your skills and knowledge allow you to invest safely.


It is also important to constantly monitor your positions and adjust them in line with market movements. In case of losses, you should be ready to act quickly and close your position to minimize your losses.

Negative balance

Investors ought to be aware of the possibility of negative balance. It refers to a situation where a trader's losses on a leveraged position exceed their account balance, resulting in a negative account balance. This can happen when the market moves against the trader's position, and the losses exceed the funds that the trader has in their account.

Suppose a trader has a $1,000 trading account and decides to open a leveraged position on BTC with a leverage ratio of 10x, meaning borrowing the remaining $9,000 from the exchange or broker to open a $10,000 position.

If the market moves against the position, and the price of BTC drops by 10% – the trader's position will lose $1,000, which is equal to their entire account balance.

In this scenario, the trader's account will have a
negative balance of $1,000, and they will be responsible for repaying the negative balance to the exchange or broker.


Negative balance with leverage can be a significant risk in crypto trading, especially when using high leverage. To avoid such a situation, traders should always use appropriate risk management strategies, such as setting stop-loss orders.


Additionally, they should always be aware of the margin requirements and the liquidation levels set. Failing to maintain sufficient margin levels can result in the position being automatically closed or liquidated, leading to further losses.


Leverage and margin

Margin and leverage are closely related concepts in trading. Simply put, margin refers to the amount of funds required to open a position, while leverage refers to the amount of borrowed funds used to magnify the potential gains or losses of that position.


The correlation between margin and leverage in trading is straightforward: the higher the leverage used, the lower the margin required to open a position.

For example, if a trader wants to open a $10,000 position on BTC with 10x leverage, they would only need to provide $1,000 as margin, while borrowing the remaining $9,000 from the exchange or broker.


Leverage in cryptocurrency investing works on a margin basis, which means that the investor must deposit a certain amount of funds as a hedge against potential losses. Margin is usually expressed as a percentage ranging from 10% to 50% of the position's value.

For example, if an investor wants to buy bitcoin for $10,000 using 10x leverage and a margin of 10%, they must deposit $1,000 as collateral (10% of $10,000).

The remaining $9,000 is borrowed from the broker, and with leverage, the investor can buy ten times as much bitcoin, i.e., for $100,000.

A significant aspect is that if a 10% decline occurs, the investor will lose all his funds with this leverage.


Margin is essential in using leverage, since it allows traders to control their risk. If the value of the investment falls, traders may require an additional deposit of collateral to minimize the risk of loss.

Therefore, investors should carefully analyze their financial capacity and choose an appropriate leverage and margin level that suits their investment skills and experience to minimize the risk of losses and increase potential returns.

Summary

Leverage and margin are crucial tools that traders can use to increase their potential profits or losses on cryptocurrency investments. Leverage works by using borrowed funds, and margin controls the risk of loss.


It is crucial to carefully analyze financial capacity and choose an appropriate level of leverage and margin that matches one's investment skills and experience to minimize risk and maximize returns.

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