What is leveraged trading?

Learning outcomes: 

By the end of this article you will understand:

1. What leverage is
2. What’s meant by leveraged trading
3. The pros and cons of leveraged trading 

What is leveraged trading? 

Leveraged trading allows you to place trades with greater risk than your capital allows by borrowing. Exchanges allow you to leverage the value of your trading capital by an agreed level, described as a ratio e.g. 5:1 or 5x. 

Greater risk means that gains and losses are amplified in proportion to the amount of leverage used. A way to understand leveraged trading is by comparing it to default trading. 

Default trading vs leveraged trading

The default method for trading any asset, including cryptocurrency, is to commit the total amount of the trade with the exchange you are buying from. 

Here’s a simple example of a default spot trade on a 1:1 basis.

• Bob deposits £100 to his digital wallet 
• Bob places a trade at the spot price for £100 of bitcoin (BTC) 
• The ratio of Bob’s trade to his market exposure is 1:1 or 100%, as his trade was for £100 and he provided the whole amount.  

This means that Bob’s £100 trade is exposed to any change in the price of BTC on a 1:1 basis. 

• If BTC goes up by 5%, then the trade nets £5 profit and the value of his capital increases by £5: £100+(£100*0.05)= £105 
• If BTC goes down by 5%, then the trade nets a £5 loss, and the value of his capital will decrease by 5%: £100-(£100*0.05)= £95 

Now let’s look at Bob making a trade with a 10:1 or 10x leverage from the same initial capital.

• Bob deposits £100 to his digital wallet 
• Bob uses his £100 as a form of collateral known as margin to leverage his trade x10 
• Total Transaction Value = Margin*Leverage allowing Bob to place a trade at a spot price for £1,000 of BTC (£100x10)

This means that Bob’s £100 trade is exposed to ten times the gains or losses compared to his trade at a ratio of 1:1.

• If BTC goes up by 5%, because of the x10 leverage, the profit of his trade increases by 50% or £50. Bob’s profit is therefore:  £1,000+(£1,000*0.05)= £1,050-£900=£150 
• If BTC goes down by 5%, because of the x10 leverage, the loss of his trade will be 50% or £50: £1,000-(£1,000*0.05)= £950-£900=£50 

Using x10 leverage means that Bob’s £100 capital can increase or decrease by 50% despite the market only moving by 5%. Given how volatile cryptocurrency prices are, leveraged trading can produce spectacular gains and losses, so should be treated with extreme caution. 

Leverage	Initial Deposit	Trade Value	Borrowed	Margin
1:1	£100	£100	£0	£0
5:1	£100	£500	£400	£100
10:1	£100	£1,000	£900	£100

 

		Price increases by 5%		Price decreases by 5%
Leverage	Margin	Trade Value	% Profit	Trade Value	% Profit
1:1	£100	£105	5%	£95	-5%
5:1	£100	£525	25%	£475	-25%
10:1	£100	£1,050	50%	£950	-50%

Leveraged trading & margin calls 

One key element missing from the simple example of Bob’s x10 leveraged trade is a margin call.

When cryptocurrency exchanges offer leveraged trading, they are, in effect, giving their customers credit. In the example above, they are extending £900 in credit to Bob because his maximum potential exposure is £1,000 if BTC went to zero.

In that extreme scenario, the exchange would expose themselves to significant loss while giving Bob ten times the benefit of any price increases. 

To mitigate the potentially negative impact of significant price movements, the exchange makes a margin call. A margin call is when the value that Bob could cash out (position value minus credit) as a percentage of the total market value of his trade falls below an agreed level, called a maintenance level.

A margin call gives Bob two choices:

• Increase the amount of margin above the maintenance level 
• Allow some of his position to be sold to adjust the maintenance level   

If the value of Bob’s position goes to zero, all his margin is eaten up and his leveraged trade is closed, known as liquidation.

Margin calls are how exchanges protect themselves against the leveraged risk that customers take on, which given that margin is available at x100, can be significant.

As crypto markets move quickly, you may not have time to respond to a margin call, which is why traders employ a tactic known as stop-loss. 

A stop-loss is an instruction to stop the trade when a certain loss is experienced. Traders will choose stop-loss levels that tell them their trade hypothesis was invalid. By introducing a stop-loss, traders preserve capital to formulate a new trading strategy. 

Who uses leveraged trading? 

Though cryptocurrencies are volatile, trading on a 1:1 basis makes it unlikely that Bob will lose his entire £100 in the short term, as this would require a 100% decline in the asset he has bought.

Mature assets, such as the foreign-currency assets held by forex traders, are far less volatile than crypto assets. With the value of foreign currencies moving only a fraction of a percent daily, leveraged trading is a legitimate way for forex traders to create greater market exposure.

The equivalent scenario in crypto is trading stablecoins. Stablecoins are designed only to move a small amount from their 1:1 peg, lending themselves to leveraged trading. However, several recent examples of stablecoin de-pegging or complete collapse illustrate the risks are far greater than with traditional currencies.

The most common use of leveraged cryptocurrency trading is by traders who want to achieve significant gains in the short term by amplifying existing volatility. This is extremely risky without effective hedging strategies.  

The advantages of leveraged trading 

Leveraged trading allows greater exposure from limited capital and/or markets with low volatility. Leveraged trading can provide a useful tool within a complex trading strategy that hedges the huge potential downside (hedging provides a mitigating strategy to counterbalance risk). 

Leveraged trading is more capital efficient, allowing traders to make greater use of their funds. 

The disadvantages of leveraged trading 

The most obvious drawback of leveraged trading is the potential for significant losses during market volatility, a key characteristic of cryptocurrency trading.

Given that cryptocurrency markets are immature, even the most experienced trader cannot account for unseen events that can whipsaw the market dramatically. 

Even unsubstantiated rumours can cause dramatic short-term declines, which can cause a cascade of liquidations, amplifying price falls and creating further margin calls.

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