What is Crypto Leverage Trading And How Does It Work?
Dec 09, 2022
Trading is a fundamental concept of economics involving the purchase and sale of valuables. It may be goods or services for which the buyer pays some compensation to the seller. In other cases, trading may involve the exchange of goods and services between parties to a transaction.
The cryptocurrency market, being one of the most volatile financial markets today, attracts many traders with an opportunity to make quick and large profits without excessive efforts. On the one hand, the volatility of this market plays into the hands of professional participants who make money on literally every price movement. Still, on the other hand, it mercilessly punishes those who decide to try their hand without understanding how the system works. In both cases, leverage increases the potential profit during trading.
This article will shed some light on what crypto leverage trading is and how it works. In addition, we will discuss the types of crypto leverage trading that exist, as well as their advantages and disadvantages. In the end, you will learn how to organize risk management in case you trade crypto with leverage.
What is Crypto Leverage Trading And How Does It Work?
So, what is leverage trading crypto? Margin crypto trading, also known as leverage trading crypto, contract for difference (CFD), or swap trading — is a type of trading, which implies using leverage of the exchange on which you are trading. Margin trading has historically been used extensively in foreign exchange markets to increase profits on small fluctuations in currency pairs. The leverage available in the currency markets is among the highest available to investors. Margin trading allows traders to open trades that can be much larger than their own capital. Under favorable conditions, a trader using leveraged trading can make a much larger profit from the transaction.
Crypto leverage is the ratio between the amount a trader can trade and the amount a trader must place to open a trading position. Leverage can sometimes be expressed as a ratio, such as 100 to 1, or as a multiple of an amount, such as 100X. Leverage makes starting with less initial capital and potentially higher profits easy. However, leverage combined with market volatility can lead to quick liquidation, especially if you use 100:1 leverage to trade. Remember to always trade carefully and assess risk before trading with leverage. Only trade with funds you can afford to lose, especially when using leverage.
A high-leverage trade can quickly deplete your trading account if it goes against you since you will incur large losses due to large position sizes. Less leverage applied to every trade gives you more breathing room, setting a wider but reasonable stop and avoiding higher capital losses. Keep in mind that leverage is completely flexible and customizable to each trader's needs.
Types of Crypto Leverage Trading
Now that you know what leveraged crypto trading is, it's time to find out what types of leverage crypto trading exists. There are two main types (modes) of crypto leverage trading.
The meaning of the cross-margin is that the entire balance provides the trader's open positions. The algorithm for this tool is very simple: on any trading account, trades exist as long as the minimum margin requirement is met. Positions in the red reduce the margin level, while profitable ones, on the contrary, increase it. In the cross-margin mode, winning one position helps meet the margin requirements of another position.
Of course, if there is a loss on all positions and the margin level falls below the platform's set level, trades will be closed automatically or liquidated. This occurs in order to avoid uncontrollable losses for the user and the platform. However, in cases where some of the trades are profitable, the cross margin becomes a very useful tool because it allows traders to survive the minus and eventually turn unprofitable positions into profitable ones or, at least, break even.
An isolated margin is a tool that implies the possibility of isolating the margin that provides some transactions from the margin of other transactions. The simplest example of the realization of this possibility is trading on two or more independent from each other trading accounts within one user account. This way, the margin between accounts will be isolated, i.e., a loss on one account will not lead to a change in the balance on the other account.
Let's imagine a trader has two separate accounts: one for working with short-term strategy and the other for long-term positions. Let's assume that the account with short-term positions has gone strongly into deficit, but trading on the account with positions opened for a longer term is going very successfully. An isolated margin between individual trading accounts implies that profits in the more successful account will not be reduced by losses in the less successful account. Also, this tool allows traders to control the profit/loss within trading strategies tied to different accounts.
Both modes of margin can be effectively applied in crypto trading. Still, it should always be remembered that trading with leverage carries high risks because of the extreme volatility of the crypto market. We will discuss how to properly hedge risks when trading cryptocurrency using leverage later in this article.
Benefits and Drawbacks of Crypto Leverage Trading
There are inherent dangers associated with each and every approach to achieving wealth through cryptocurrencies. Crypto trading with leverage is one of the easiest ways to multiply your deposit with a clear strategy and relevant knowledge. However, like any other way, crypto leverage has benefits and drawbacks.
Benefits of Crypto Leverage Trading
First, let's take a look at a few important benefits that come with using leverage.
1. High Yield
The main advantage, as well as the most obvious one: is that with the right strategy and understanding of the movement of the cryptocurrency market, you can achieve excellent returns even with a small initial capital. The more leverage offered by a crypto exchange, the more substantial the profit.
2. Ability to Trade Short
Using leverage, regardless of the exchange on which the trade is conducted or of the selected trading instrument, provides an opportunity to trade in shorts. The trader opens a short position when he tries to profit from the market decline in the short term. To do this, he borrows crypto assets from the exchange and sells them on the market in anticipation of a price drop. When they fall, the trader repurchases them and returns them to the exchange, keeping the difference in price for himself.
3. Ease of Use
In addition to the above benefits, using leverage is a fairly simple process and does not require deep knowledge of crypto trading. With a clear strategy in place, all you need to do is decide on the crypto asset you want to trade. Next, you choose the margin mode, cross or isolated, adjust the initial deposit size, leverage level and the price of the asset at which the buy or sell order will be placed.
Drawbacks of Crypto Leverage Trading
Despite the impressive advantages that crypto trading with leverage has, this method has significant disadvantages. Here are some of them.
1. High Risks
Using leverage multiplies income proportionally, but only if the price moves in the direction of the open position. In the opposite case, losses accrue to exactly the same extent. This can lead to lightning-fast profits as well as equally dramatic losses. To calculate the optimal leverage value, it is necessary to pay attention to the average volatility of the instrument's quotations. The higher it is, the more likely you risk substantial losses from occasional fluctuations when using high leverage.
2. Limited selection of assets for trading
Not every crypto asset is available for margin trading. As a rule, exchanges give an opportunity to use leverage to trade the most popular and highly liquid assets. The exchange independently determines the level of leverage available to a trader in trading a particular asset, and it can change the terms at its own discretion, depending on the situation in the crypto market.
Unlike spot trading mode, the use of leverage not only in crypto but in any other type of trading involves payment of a certain percentage to the exchange for the opportunity to use additional margin to increase profits. Each exchange independently sets the percentage for each of the trading instruments available for trading. Before using leverage, it is necessary to study in detail the terms of the loan on the exchange.
Risk Management in Crypto Leverage Trading
While trading with leverage can generate higher profits if a trade is successful, if it fails, it carries the risk of increased losses. However, there are various risk management (hedging) tools that can help avoid liquidating a position and reducing potential losses.
Setting a Stop Loss and Take Profit
Every trader working with cryptocurrencies or any other assets knows the importance of using these risk-hedging tools because they provide a near 100% guarantee that your order will be closed both in a falling market and in an ascending market if the trend goes against your position. Stop-loss and take-profit can be considered the basic tools that are used for the proper implementation of the strategy, as well as to simplify the process of trade.
Setting Low Leverage
Leverage is undoubtedly one of the key advantages of the crypto market. The main problem is that most beginning traders try to choose the maximum possible leverage. In reality, higher leverage can only be profitable if used correctly. New traders are more likely to succumb to the misconception that higher leverage will produce faster and better results. Eventually, when the position does not work in their favor, they incur higher losses, resulting in less margin for their next trade. Beginning traders should only choose the level of leverage they feel most comfortable with. A lower level of leverage may be more appropriate if you are a conservative trader and do not like to take risks.
Cryptocurrency trading with leverage is very profitable and allows you to multiply a relatively low initial deposit. However, leverage, despite its impressive profits, can lead to the rapid liquidation of a trader's position, especially when using a high leverage ratio. So, develop the right strategy, always be aware of the risks, and invest only those funds you are willing to lose.