Leverage Crypto Trading: How Does It Work? | CoinGecko (2024)

Leverage is one of the tools experienced traders use to increase trading profitability. You can apply it in various markets, such as crypto, stocks, forex, etc. Essentially, leverage enables you to trade at a bigger capacity with minimal resources, maximizing returns.

Are you planning to learn about leverage trading in crypto but aren’t sure how to get started?

This guide takes you through everything you should know about the basics of leverage cryptocurrency trading, from what leverage trading is, how it works, to how to calculate leverage and how to mitigate risks of leverage crypto trading.

Let’s get started.

What is Leverage Trading in Crypto?

Leverage cryptocurrency trading is when you borrow assets from exchanges to amplify your trading capacity. In other words, you borrow to increase your buying and selling power in the market. This way, you end up operating with more capital than you actually have.

Moreover, there are various leverages based on the exchange you use. Some exchanges provide up to 20x your wallet deposit – if you have $500 in your wallet, you can trade with sizes up to $50,000!

Usually, you describe leverage with “X” to indicate the multiplier, like 2x, which translates to two times leverage, allowing you to open a position 2x your initial deposit. As such, the ratio depicts the number of times the broker multiplies your wallet deposit. For example, if you deposit $200 in your wallet and open an ETH position with a 10x leverage, your $200 turns into $2,000 worth of capital because $200 x 10 = $2,000.

Apart from using leverage to trade crypto, you can use it to trade cryptocurrency derivatives, futures contracts, etc. However, there is no free lunch;by providing you with increased rewards, this also means you are undertaking increased risks that can cause huge losses.

To understand how this happens, we need to understand how leverage trading works.

Firstly, you must deposit assets into your cryptocurrency trading account to open a leveraged trade. The deposit acts as collateral and varies based on the leverage you choose and the total amount of the position or margin you want to open.

For example, if you want to trade $500 in BTC with 2x leverage, you must deposit minimum collateral of $250 in your account. In this regard, you should always remember that the more leverage you use, the higher returns you will generate but the higher losses you will incur if the trade goes against you.

Other than the collateral, exchanges also require leverage traders to maintain sufficient margin for their trades. If the price of the asset that you are leveraged trading goes in the opposite direction, your margin will start to drop. If the margin declines towards $0, your broker will request you to add more assets into your account or they will perform a forced liquidation, where your trading position will be closed due to inadequate funds, and usually also incur a liquidation fee.

Why Should You Use Leverage in Crypto?

Experienced crypto traders might consider using leverage if they want to build their trading position sizes and maximize profits. We will use another leverage trading crypto example to demonstrate this point.

Let’s assume you only have $400 in your account, but you want to have more capital for trading. You can execute your plan by using leverage as shown below:

2x leverage:
$400 x 2 = $800. Thus, you can have an $800 exposure with just $400.

5x leverage:
$400 x 5 = $2,000. Hence, you can obtain $2,000 worth of crypto exposure using $400.

From the illustration above, it’s evident you can leverage to obtain a significant amount more exposure of an asset with minimal capital in your trading account.

Now that you understand why experienced traders may want to use leverage in crypto, let’s briefly see how you can use leverage in crypto to master this topic better.

You can leverage trading crypto by going long or short. If you predict an asset’s price will increase, you can take a long position/buy. But if you strongly feel the price will decrease, you can open a short position/sell.

As such, if you open a long position on ETH for $2,000 with a 2x leverage, you simply need to deposit collateral of $1,000. If ETH increases by 30%, you generate 60% in profit, or $600.

$1,000 x 2 (leverage) x 30% = $600

You will use a portion of the profit to pay funding rates and transaction fees but you will realize the impact of leverage is larger than just using a capital of $1,000 as you would only make a profit of $300 in that case. This works for shorting, or betting that prices go down, as well.

Now, let’s see what happens when you create a short position with 2x leverage. Using $1,000 as collateral, a 2x leverage means you will have $2,000 in your account to short. If ETH depreciates by 30%, you can buy back (close the short position) and earn a profit of 60%.

$1,000 x 2 (leverage) x 30% = $600

How Do You Manage Risks With Leveraged Trading?

While trading crypto futures can be highly rewarding because of the high leverage offered, the losses can be equally huge and sometimes bigger than the collateral. Therefore, it’s important to have a reliable risk management strategy. Below are three risk management strategies to apply in leverage cryptocurrency trading for maximum returns.

1. Establish Your Risk Per Trade

Inexperienced traders often open big trade sizes, hoping to reap big rewards. That’s awesome if your trade goes as planned, but you must consider what might happen if your trade doesn’t go as planned. As such, you should use a stop loss to cap your trading losses.

Assuming you are already using a stop loss, what percentage of your investment should you risk when your stop loss is hit?

Source: megha investments

From the statistics shown in the image above, it’s evident a minimal percentage loss requires an achievable percentage gain to regain your initial capital. For example, 5% and 10% percentage losses require almost similar percentage gains to recover (5.3% and 11.1% respectively).

On the other hand, high percentage losses require exponentially high percentage gains to regain your original capital. For instance, 90% and 95% percentage losses require percentage gains of 900% and 1900% to recover respectively. This means that it will be challenging to even recover your initial investment when your plan backfires.

In this regard, it’s advisable to only risk 2% of your trading amount per trade. In other words, after establishing your stop loss, you should set the amount of money you lose after your trade hits a stop loss to 2% of the trade. For instance, if you were leverage trading with BNB worth $20,000, then 2% risk implies adjusting your trading size so that you lose $400 after hitting your stop loss.

Why is it 2% and not 15% or 25% risk per trade? Though 15% or 25% risk per trade is more profitable, you could easily blow up all your investment in less than five poor miscalculations. As such, the 2% risk per trade aims to leave you with substantial funds in your trading account even after incurring multiple consecutive losses.

2. Filtering Your Trades Using Risk/Reward Ratio

After determining your risk per trade, you should scan your trades using the risk/reward ratio. Remember, each trade you open entails exposing a portion of your investment to risk in exchange for potential profits.

You should establish your stop loss and take profit levels for every trade precisely through insights you get from your technical analysis and other trading strategies. These levels will enable you to find the rewards for each amount you risk per trade or the risk/reward ratio.

For instance, if you set your stop loss as $400 and the take profit as $2,000, then your risk/reward ratio is 5:1.

It would be best if you also determined your average win rate to maximize the risk/reward ratio. Generally, you can use the back-testing method to calculate your average win rate for every trading strategy. Moreover, you should only open trades with better risk/reward ratios based on your average win rate.

3. Determining Your Position Size

Now that you know your risk per trade and your risk/reward ratio, you can determine the amount of money you should invest per trade. Luckily, most exchanges offer trading tools for calculating profits/losses in leverage cryptocurrency trading.

After setting your entry and stop loss levels into the leverage calculator, change your investment amount (position size) so that the losses you incur after hitting the stop loss correlate with your risk per trade– recall point one: ‘Establish Your Risk Per Trade’.

Besides, you should factor in the liquidation point. Consider modifying your trade parameters if your position hits a liquidation point before a stop loss.

Pro-tip: You should avoid getting liquidated as there will usually be additional fee incurred. You can use stop limit orders right infront of your liquidation price instead so that you close your own position instead of being liquidated.

What is Margin Trading?

We can likenmargin trading to buying on credit. In other words, you borrow assets from a broker to use them to make trades. The act of using margin to trade is referred to as leveraging since it entails borrowing funds to maximize profits.

Although margin trading and leverage trading is similar and interconnected, they are not the same. Margin trading uses capital deposited in your account as collateral to borrow more funds from the crypto exchange for trading purposes. However, leverage trading involves borrowing more credit from the platform in order to amplify the size of your trading position.

Margin capital is a secured loan and thus bears an interest rate and requires a collateral, which your exchange sets. Moreover, your account level and the amount you borrow significantly affect your interest rate. In margin trading, you should also retain a margin balance, commonly known as a maintenance margin, in your account to take care of losses. Additionally, you must deposit some funds to act as security collateral for the assets you borrow.

On the other hand, leverage trading often involves the trading of perpetual contracts that does not use an interest rate but rather a funding rate. A perpetual contract is a type of futures contract that enables you to trade an asset with leverage but with no expiry date, with the price of the perpetuals derived from the underlying spot market and remains closely linked through the funding rate.

A funding rate refers to intermittent payouts made to investors based on the difference between perpetual contract markets and spot prices. Funding rate helps to ensure that the price of the perpetual contract remains closely tied to the price of its underlying spot market. For example if the price of the perpetual contract is higher than the underlying spot price due to more traders going long, the funding rate becomes positive, and the wider the price difference, the larger the funding rate. When this happens, traders that goes long have to pay traders that goes short. This incentivizes more traders to go short and push the price back to the underlying spot price.

Lastly, liquidation is the forced closing of a trader’s position because of the fractional or complete loss of the initial margin. This often occurs when traders lack adequate capital to maintain their positions.

Calculating Leverage

Here is the formula for calculating leverage in crypto:
Leverage = 1/(Margin) =100/(Margin percentage)

Assuming the margin is 0.04, then the margin percentage is 4%
Leverage is 1/0.04 = 25

To find the margin used, multiply your trade size by the margin percentage.

Calculating Liquidation Price

It is equally important to know the liquidation price of your leveraged position. Although exchanges will always give you the liquidation price, it is good to know how it is calculated.

The simple equation is:

Liquidation price = entry price – (1/leverage ratio) * entry price

For example, if your entry price is $1000 and your leverage is 10x, your liquidation price would be:

$1000 - (1/10) * $1000 = $900

Another way to think about it is, 1 over your leverage ratio is the percentage price movement that will hit your liquidation price.

If your leverage is 10x, then 1/10 is 10% and thus a 10% movement in the opposite direction your liquidate your position.

Note that this is only applicable for isolated margin, and cross margin uses a different formula.

Platforms for Leverage Crypto Trading

These are some of the best exchanges for leverage cryptocurrency trading:

Binance

Binance is the leading crypto exchange in transaction volume. Initially, Binance only supported spot trading, but in 2019, they started supporting leverage crypto trading. You must pass the Know Your Customer (KYC) identification process and be a non-US citizen to qualify for Binance’s leverage trading.

Depending on your coin pairing, Binance leverages differ and can be up to 20x. Interest rates also vary based on your margin account level and the type of asset you borrow. When you pay your interest rates using BNB, you’ll receive a 5% discount.

Apart from that, Binance has put up a Margin Insurance Fund to secure its liquidity. If you go bankrupt during leverage trading and your funds are insufficient to clear your debts, then the platform clears your debt using the insurance fund.

Kraken

Kraken is a US-registered crypto exchange and allows US crypto traders to participate in leverage trading. It has been in operation since 2014, and it’s among the biggest exchanges by daily transaction volume.

Because of the stringent US laws, Kraken offers up to 3x leverage. While this leverage looks dismal compared to Binance, it’s ideal for now and will likely improve as the US adopts a clearer crypto regulatory framework.

You can open long and short leverage trading positions for Bitcoin, Bitcoin Cash, Ripple, Ethereum, and more on Kraken. The exchange is proactive in providing better customer support to its users; therefore, they will guide you accordingly on how to move along.

Conclusion

Leverage cryptocurrency trading improves your buying and selling capacity by allowing you to operate with more capital than what you have. Nonetheless, the crypto market is highly volatile, and high leverage can cause liquidation risks. Therefore, always trade with caution and conduct a thorough technical analysis of an asset before leveraging it. Above all, never risk more than you can afford to lose.

Crypto beginners are advised to keep off leverage trading as it’s a highly risky investment strategy. Otherwise, professional traders can use leverage to maximize trading profits if they properly manage it.

If you enjoyed this article, read our guide onhow to read candlestick charts and patterns.

FAQs

What is 20x leverage?

A 20x leverage means your broker will multiply your account deposit by 20 when trading on leverage. For example, if you deposit $500 in your wallet and open a BTC position with a 20x leverage, your $500 turns into $10,000.

What is a leverage trading crypto example?

Leverage trading crypto is when you borrow assets from a broker to amplify your trading position. Below is a leverage trading crypto example:

Let’s assume you want to purchase ETH worth $2,500, but you only own $250 in your account. In this case, you can still achieve your dreams by using a leverage of 10x. If your trading plan goes as projected and you make a profit of $1,500, you will return the borrowed funds and interest to your broker and keep the balance.

How long do leverage positions remain open?

The maximum period most exchanges will allow you to maintain your leverage positions is one year. You should monitor your open positions throughout this time to ensure you don’t miss your token’s peak price for maximum profits.