What is Leverage?
Leverage is the ability to use borrowed capital to amplify ones buying or selling power resulting in the trader being able to open bigger positions.
Without the use of Leverage, a trader is not only limited to the amount of capital in their account, but they are only able to speculate on the appreciation of an asset. This limits the trader to only being able to trade ‘Long’. This is commonly referred to as Spot Trading.
Of course, this does have its benefits and is considered a lot safer, but it does come with its limitations.
For example, assume a trader has deposited $1,000 into their account. Without using Leverage, the trader is only able to place a maximum position size of $1,000. If Leverage is used, the trader could open a position of up to $125,000.
What are the Different Types of Leverage?
There are two main types of Leverage available to traders: Cross and Isolated.
Cross
Cross Leverage is a method that utilizes the full amount of funds in your account meaning the whole account is potentially at risk.
For example, if you have $1,000 in your trading account and you open a position, if you fail to utilize a Stop Loss correctly and your trade goes against you, your whole account has the potential to be liquidated.
This method is only recommended for traders who have a sound knowledge of how Cross Leverage works on the platform they are trading on.
Isolated
Isolated Leverage allows the trader to choose the amount of Leverage they wish to use. Most exchanges offer between 1-125x. Using this option allows you to limit your loss to the initial collateral or margin on the trade and not your whole account.
For example, if you have $1,000 in your trading account but you open a position with $400 as collateral, only the $400 is at risk of being liquidated while the remaining $600 is safe.
This is the recommended method for traders beginning to use Leverage.
What are the Risks to using Leverage over Spot?
When choosing to trade with Leverage it does pose more risk than trading with the traditional Spot method. Lets have a look at some comparisons between Leverage vs Spot:
Spot
- When you purchase Crypto using Spot, you own the asset. Meaning it is in your custody allowing you to transfer between wallets.
- Anything purchased using Spot can be held indefinitely. There is no risk of liquidation and no on-going fees.
- Your position size is limited to the amount of capital in your account.
- You can only ‘long’, meaning the only way to profit is from price appreciating.
Leverage
- When you purchase Crypto using Leverage, you are trading a derivative of the underlying asset. Meaning you do not own it and are simply speculating on whether you think the price will go up or down.
- You have the risk of being Liquidated.
- Depending on the contract being traded, there could be on-going fees to be paid on open positions known as ‘funding fees’.
- You may have to pay higher fees to enter a position as they are usually calculated on the number of contracts purchased. The higher the Leverage used; the more contracts need to be purchased resulting in a higher fee.
- You can ‘borrow’ money to take larger positions.
- You can take ‘Long’ and ‘Short’ positions allowing you to profit from the market moving up or down.
It is also important to note that trading Leverage does not increase the amount of profit you make, it only reduces the amount of your own money you need to take the trade. This could effectively lead to you making more money though, as you may not have had enough capital to take the trade unless Leverage is used.
For example, assume you have $1,000 in your trading account and you are risking 1% of your total account per trade:
With a $1,000 account size you can see that you would not have enough money in your trading account to enter this $1,538.46 position unless you used Leverage. The only way to enter this trade is with the full $1,000 which would reduce your risk down to 0.65%.
If 25x Leverage was used, you would only need to put down $61.53 as collateral. This would allow you to open up more Leveraged positions with your free capital if you needed to.
You can see here that the profit made from both the Spot trade and the Leverage trade ends up being the same amount. Remember that Leverage does not increase your profit, it only reduces the amount of your own money you need to take the trade.
What is a Liquidation Price?
When you trade with Leverage you essentially ‘borrow’ your position and put up a certain amount of your own money as ‘collateral’ or ‘margin’.
In the above example, you want to borrow $1,538.46 at 25x Leverage. The collateral you need to service that loan is:
$1,538.46 / 25
= $61.53
The collateral is used to repay the lender if your trade goes too far in the opposite direction. There is a certain price point at which your losses will become more than what you can repay and so the exchange will automatically close your position to ensure you can repay what you borrowed in full. This is called your Liquidation Price.
If you are Liquidated, you will lose 100% of your collateral on that trade, resulting in a much larger loss than the original 1% you were willing to risk.
The higher the Leverage used, the closer your Liquidation Price will be to your Entry Price.
This is why it is extremely important that you ensure your Stop Loss will be triggered BEFORE your Liquidation Price.
Having a sizable distance between your Stop Loss and Liquidation Price is recommended because during times of high volatility, if your Liquidation Price is close to your Stop Loss it may result in your Stop Loss being ‘skipped’ and your Liquidation Price being hit.
If the Liquidation Price is close to your Stop Loss, you can reduce the amount of Leverage used to shift that Liquidation Price further away from your Stop Loss.
Most exchanges will show you your Liquidation Price before you enter a trade so you can make any adjustments before executing the position.
Futures Markets & Funding Fees
When trading Leverage, the two most popular futures markets to trade are the Perpetual Futures and the Traditional Futures. Lets have a look at some comparisons between the two:
Traditional Futures
- Contracts have an expiry date which can range from weeks to months. This means that if you have any open positions at the time of expiry, they will be automatically closed at market price.
- Leverage available.
- No Funding Fees.
- Usually, less volume and liquidity than Perpetual Futures.
A Traditional Futures contract is more suited to a trader who holds positions for longer periods as they do not require you to pay on-going funding fees.
Perpetual Futures
- Contracts do not have an expiry date.
- Funding Fees are payable generally every 8 hours, but this differs between exchanges.
- Leverage available.
- Usually, there is more volume and liquidity than a Traditional Futures market.
A Perpetual Futures contract is more suited to a day trader or someone who holds positions for less than a couple of days.
This is because of the way the Funding Fees work. Generally, Funding Fees are calculated and charged every 8 hours depending on what side of the orderbook your trade is.
The Funding Fees are not a fee that is payable to the exchange but a fee that is payable between longs and shorts.
If the Spot price of the underlying asset is higher than the Futures price, the funding fee will be positive, and longs will pay shorts.
If the Futures price is higher than the Spot price of the underlying asset, the funding fee will be negative, and shorts will pay longs.
In the image below you can see the current funding rate is positive so longs will pay shorts and the next funding rate is estimated to be negative so shorts would pay longs.
Auto Deleveraging
It is also important to touch on Auto Deleveraging. I’m not going to go into detail on what that is in this article but in the rare event that an Auto Deleveraging occurs, positions with the highest Leverage and unrealized profit are prioritized to have their positions closed to pay back any losses incurred by the exchange. This is usually done by the exchanges Insurance Fund but if it is rapidly depleting, an Auto Deleveraging can occur.
To avoid having your position closed a trader can reduce the leverage of the position or close partial/all positions with a high profit ratio.
Summary
In conclusion, Leverage can be a very powerful tool if used correctly but a trader needs to understand how it works on the platform they are trading on as each exchange can differ slightly.
Without the knowledge of how the Leverage system works, a trader is exposed to greater risks through liquidation, incorrect use of funding fees and over-risked positions.
Happy Trading!
