When trading in crypto, leverage allows you to borrow money from an exchange to multiply your investment. When you pay back your loan you will have either multiplied your earnings or your losses. In this article, I will walk you through all you need to know about using leverage in crypto.
What’s leverage in crypto trading?
Leverage is a double-edged sword that increases your buying power to multiply your winnings but can also do the same to your losses if you are not careful.
To trade on leverage means that the crypto exchange is lending you money to multiply your position.
For example, say you have $1,000 USD to invest.
A 10% profit translates into $100 in your pocket.
But if you trade on 20x leverage then you are able to invest $20,000.
A 10% profit would mean $2,000 in winnings.
See what happened here?
You invested $1,000 and came out with $2,000 in profit margin.
That’s 100% ROI.
The problem is that if the cryptocurrency market had moved in the opposite direction you would now owe $2,000 + fees to the exchange.
This means you would have lost all of your initial capital of $1,000, and then the cryptocurrency exchange would have sold other assets in your account to get the remaining $1,000 plus leverage fees plus penalty fees.
So how does training on leverage actually work? Let’s take a closer look.
How trading on leverage works
Continuing with our example, say you have $1,000 to invest.
This is known as your initial margin.
The trading platform will lend you all the way up to 20x depending on the trading pair but up to 5 x leverage is most common.
Say you go for 5x.
This means that your total trading position is now $5,000.
You can go long or short on your trade.
Taking a long position means you expect the price to go up.
And by taking a short position, you are betting that the price of the crypto asset will drop.
Let’s keep it simple and assume you go long.
Say you are buying Polkadot (DOT) and that one DOT is equal to $1.
This means that you can buy 1,000 DOT without leverage but with leverage, you can now buy 5,000 DOT.
Now imagine the price of DOT increases to $1.2.
Your 5,000 DOT is now worth:
Awesome, after you pay back the principal you borrowed you will have:
Wait how much are the fees?
When trading on margin the fees are quite high.
For example, Kraken charges 0.01%-0.02% every 4 hours which on an annualized basis is between 22% and 44%.
Most often, when you trade on leverage you will be doing so within a small time frame which means your fees won’t be that high.
For example, if the trade above took a week then your fees would be about $33.6 at 0.02% interest every 4 hours.
That’s only 0.336% of the profit of $1,000 that you made.
In addition, you need to account for the trading fee when you place the trade plus any penalty fees in the scenario where you get liquidated.
But what happens if the price moves against you and you end up with a lower price?
Liquidation ratio and margin call explained
Another way word for trading on leverage is margin trading.
Your initial margin equals your initial capital when you start off.
Think of this as a security pillow that you are offering the exchange.
In our case, our initial margin was $1,000.
When the price starts moving your margin also moves.
When the price rose to $1.2 your margin increased to $2,000.
This new level of comfort that you are now making available to the exchange is called a maintenance margin.
What happens to the maintenance margin when the price drops to $0.9?
Oops, your maintenance margin is now:
$1,000+ (5,000 DOT*$0.9-$5,000)=$500
In order to decide what to do the exchange will look at your margin ratio.
Your margin ratio, also known as the leverage ratio, is your maintenance margin divided by your account equity.
Assuming you only had $1,000 in trading capital on the crypto exchange your margin ratio is:
At this point the exchange might do a margin call i.e. it might issue you a warning that you need to add more capital to your margin position otherwise you could risk getting liquidated.
Every exchange has a liquidation ratio at which they will forcefully close your position.
For example, they might make a margin call when your margin ratio is at 50% and liquidate your assets when it drops to 20%.
You will need to read the specific terms and conditions of the exchange you are using to know the liquidation ratio.
Here are the T&Cs for leverage trading for 3 of the largest exchanges that offer leverage trading.
How not to lose your money
Most people lose money when they first start trading on leverage.
I would highly recommend that you do not trade on leverage if you are an inexperienced trader.
However, if you want to give margin trading a go make sure you do the following
#1. Manage your emotions.
The worst mistake you can make when trading on margin is to start seeing your maintenance margin drop and just sit there hoping that it will go back up again.
You need to be emotionally prepared to take that small loss and sacrifice your dreams of hitting the jackpot real quick.
When you take a levered position here is what’s going to happen.
You’re going to start thinking:
“Wow, I just need to make 10x two or three times and then I could be a millionaire”
Your mind plays up the scenario with all the wonderful things that could happen when you become a millionaire.
You could quit your annoying job. Buy that guitar you always wanted. Travel the world. Get a house or apartment. Pay off the mortgage or student loan.
You will be free!
It will be so awesome.
And when the price starts moving in the opposite direction you won’t want to let go of that dream. You’ll say, “Nah it will go back up. Let’s go for it. What’s done is done”.
And that’s how you will lose all your capital.
The trick then is to manage your psychology and be willing to take frequent small losses counterbalanced by infrequent outsized wins.
And here is the way to do that.
#2. Use stop-loss orders or limit orders to cut potential losses
A stop loss will set a market order after a specified price has been reached.
In our example above you could set a stop price of $0.95 which instructs the exchange to sell if the price of DOT drops to $0.95.
This way you lose $250 but you avoid losing everything if the price continues to drop.
#3. Don’t be greedy
Prices have momentum built into them so when they start dropping they are unlikely to move back in time for you to gain back your maintenance margin.
In order to allow more leeway though for this to happen you should avoid taking more than 2 to 3x leverage.
For example with 2x leverage a 5% drop to $0.95 would mean -$100 in losses instead of $250.
#4. Exit the trade and take profits
When you first trade on leverage you are going to be looking at your phone every 5 minutes.
But the price is not going to move immediately. It might, however, move overnight when you are asleep.
For this reason, it would be good to set a take profit order or limit order to capture any sudden upside.
Take-profit orders are useful because they instruct the exchange to sell after a specific price has been reached.
For example, you could set a take profit when the price hits $1.1. This way you make $300 on 3x leverage.
Which is 30% ROI on your trade.
For more about limit orders and other order types check out the following resources:
- Binance Limit Vs Market Order: Understand the Difference
- How to Set Limit Order on Coinbase App in 6 Steps
#5. Don’t use all your capital
Professional crypto traders avoid taking large positions and never trade more than 1% of their trading capital.
They also use technical analysis to manage their open positions.
Disclaimer: Please keep in mind that the above is based on my personal experience and the books I have read. However, I am not your financial adviser and you should do your own research when it comes to cryptocurrency trading. A book I recommend to my friends to understand crypto trading is The Crypto Trader by Glenn Goodman. I get a few cents if you buy it from that link.
Steps to trade on leverage
- Log into your exchange using two-factor authentication.
- Choose the cryptocurrency that you want to trade. The exchange will have a number and an x next to it to indicate how much leverage they offer on the asset. With some exchanges, e.g. Binance, you are required to complete a training and pass a quiz before you can trade on leverage. Binance in particular requires that you have $10,000 in your trading account. Other exchanges such as Kraken allow you to directly trade with any amount up to 3 or 5x depending on the trading pair.
- Select the amount of leverage you want.
- Place a buy or sell trade depending on whether you want to go long or short.
- Once you place your levered trade make sure you place a stop loss order to cut your losses and a take profit or limit order to lock in any upside.
How does 20x leverage work?
20x leverage means you are borrowing 20 times you trading capital to increase your position by 20 times. For example if you have $100 your position becomes 20*$100=$2,000. After you close your trade you need to pay back $1,900 plus fees.
Is it good to leverage crypto?
Trading on leverage is highly risky. It's a powerful tools that can result in higher profits but also in significant losses. Most inexperienced traders tend to lose all their money this way.
Does 5x leverage mean 5x profit?
5x leverage could result in up to 5x profits or 5x losses. In the case of losses, if your trading capital does not suffice the exchange could sell other assets that you hold in your account balance with them to cover the principal plus borrowing fees plus liquidation penalty fees.
Can you lose more money with leverage?
Yes, leverage trading entails high risk and you can easily lose money with leverage if the trade moves opposite to what you expect. In extreme cases you could loses both your initial investment plus some or all of your other digital assets you hold with the exchange.
How much leverage is too much crypto?
As a rule of thumb more than 3x leverage is risky and more than 5x is extremely risky.
Does Binance offer 100x leverage?
Binance used to offer 100x leverage but now only offers up to 20x leverage. You also need to deposit a minimum of $10,000 or the equivalent in digital assets and pass a quiz.
What is 5% on a 10x leverage?
A 5% increase in price on a 10x levergae would result in 50% profit. E.g if you invest $1000 at 10x and price rises by 5% tou make $500.
How much is $100 with 20x leverage?
You trading position would be 20x*$100=$2,000. At the close of the trade you would need to repay $1,900 plus fees.
You get liquidated in crypto when you have borrowed money from an exchange and the price moves against you. Here is how it works. Read more.