Leverage trading is a core concept of cryptocurrency trading. This article will explore what leverage trading entails, how it works, and the advantages and risks of employing it.
The basics of leverage trading
Leverage trading, also referred to as margin trading, involves users borrowing funds to trade with a larger capital base, allowing for potentially amplified returns but also increasing the risk of losses. It allows traders to open larger positions with the capital in their account.
In traditional markets, leverage trading is typically carried out through a margin account, which allows traders to borrow funds from a broker to open larger positions. The trader must maintain a minimum balance in their margin account, which acts as collateral for the borrowed funds. Suppose the value of the trader's account falls below the minimum balance. In that case, the broker may issue a margin call, requiring the trader to deposit additional funds or sell some of their position to reduce exposure and bring the account balance back to the required level. If the trader fails to satisfy the margin call, the broker may proceed with liquidation, selling the trader's positions to repay the outstanding debt to the broker.
Leverage operates similarly on dYdX, and margin is offered through the exchange to trade perpetual contracts. Users can trade up to 20 times their capital (20x leverage) on specific markets, with each market varying based on conditions.
Leverage trading example
Suppose a trader has $100 in their account and wants to trade an ETH-USD position worth $1,000 with 10x leverage. They can use the $100 of their capital and borrow the remaining $900 from dYdX. If the position doubles in value to $2,000, the trader can close the position, returning the initial $900 to the exchange and earning the trader $1,100 in profit. If the position depreciates, the trader can close the position to limit their losses. In either case, the trader must repay the borrowed funds that were leveraged in the position.
It’s important to note that leverage trading carries a higher level of risk as the trader is using borrowed funds, which must be repaid regardless of the trade outcome. If the market moves against the trader, their losses can quickly exceed their capital, leading to a margin call and a forced liquidation of their position. It’s crucial for traders to carefully consider their risk tolerance and implement appropriate risk management strategies when trading with leverage.
Advantages and disadvantages of leverage trading
- Capital efficiency: By using borrowed funds, traders can deploy their capital to access larger positions than possible with their funds alone. The collateral deposited becomes efficient by supporting larger positions. If the trade is successful, the trader can earn a higher return on their capital.
- Increasing returns potential: Leverage allows traders to open larger positions than otherwise possible, thus increasing the potential returns if the trade is successful.
- Potential for losses: Just as leverage enables higher returns, it also puts traders at risk of more significant losses on their positions. If the position turns negative, the losses are amplified due to the larger position and the use of borrowed funds.
- Liquidation: When a trade is executed with leverage, the exchange sets a liquidation price on the position, usually set at a small loss, but this varies based on the leverage amount. If the market hits this price, the position is automatically closed with a market order, realizing losses for the trader. These losses can be substantial, potentially wiping out the entire collateral in the account.
- Complexity and risk: Trading with leverage requires understanding markets, risk, and the exchange mechanics involving margin and liquidation. Traders face additional complexities and risks that are not present in regular trading.
With an understanding of how leverage trading works, traders can optimize their capital deployment and potentially earn higher returns on their positions. However, traders must also be aware of the increased risk of greater losses and liquidation events. Traders must learn the complexities of leverage trading and implement appropriate risk management strategies to protect their collateral.