What’s wrong with leveraged crypto trading

If you are interested in the dynamics of crypto markets, you will need to understand how leverage works. Leveraged crypto trading is a technique that allows you to trade up to 100 times larger than your capital would normally allow, magnifying both potential gains and losses. This type of high stakes trading should be reserved for the professional, but since it can also impact price – accentuating moves in both directions – it is important to understand how leveraged trading works, to understand the crypto market.

By far the bulk of trading in the financial markets is foreign exchange – often abbreviated as forex. Traders will speculate, for example, on the value of the US dollar against the euro, or the pound sterling against the Swiss franc.

The daily fluctuation range of these established currency pairs is very small, a fraction of one percent. In order to make meaningful trades, a trader would need a huge amount of capital, for what could be very modest returns.

The solution is to place leveraged trades. Leverage essentially amplifies the potential return of a given trade by a fixed multiplier, say 10x, but without the need for an equivalent amount of capital.

In order to place a leveraged trade, a trader needs a broker or an exchange to essentially extend credit in order to be able to place leveraged trades. However, this credit is not unconditional. There must be red lines to limit losses, which are theoretically far beyond what the trader has at his disposal.

If all goes well, this leveraged trade produces larger returns without having to commit a huge outlay. If the trade goes in the wrong direction, however, the losses are also magnified and the broker will set a trigger beyond which the credit agreement will not extend.

Margin – This is the amount of money you place in your margin trading account, providing the collateral against which the exchange is willing to extend credit.

The sink – The degree to which the trade will allow you to amplify your Margin, expressed as x2, x5, x10, x100 etc.

Margin report – The amount of margin required by the exchange in relation to the position. It is the inverse of the level of leverage. So, x2 leverage means your margin ratio will be 50%. Spot trading basically has a 100% margin requirement because to place a spot trade you must fully fund the position from your account balance.

Maximum position – Your margin multiplied by leverage. So, if you place €1,000 in your margin account and the available leverage is x10, your maximum position will be €10,000.

margin call – The point at which the exchange will ask you to add more funds to your margin account in order to maintain the margin ratio – given the drop in your position – or reduce the amount of leverage.

Liquidation – When your Margin is automatically sold to cover the losses suffered by your Position.

Long/short position – When using leverage and betting that the price will rise, you are taking a long position, the reverse is taking a short position.

stop loss – Set a loss level at which the trade is automatically canceled. Traders would see this as the point that invalidates their prediction, accepting the loss but preserving capital to remain liquid. Not using a Stop Loss is extremely risky as it exposes you to liquidation on evert trade.

If you start with €10,000 in your exchange account and make a regular trade (without leverage) that achieves a 10% gain, you will earn €100 (1,000 * 0.10) and end up with €10,100 , increasing your overall funds by 1% ( 100/10000)

If the trade made a loss of 10%, you would lose €100 and end up with €9,900 or 99% of your starting bankroll, or a loss of 1% of your trading capital.

If the exchange offered you x10 leverage, you could execute the same trade, but your €10,000 would act as margin, and you would be able to trade a maximum position of $100,000 because your margin ratio would be 10 %.

Now, the 10% gain would result in a profit of €1,000 (10,000*0.10) – a 10% increase in your overall capital – or a loss of €1,000, leaving you with only 90% of your starting capital.

With this amplification, it wouldn’t take many trades to double your money or potentially wipe you out, with x100 leverage either scenario could happen with just one trade.

Let’s look at the flip side – the basic results of a 10% drop on a long position – highlighting the three scenarios, unleveraged, x10 and x100, and their impact

With x100 leverage, you will get a margin call before your losses reach 10%, which requires more margin or lowers your leverage, but in reality, crypto is so volatile that you could easily be liquidated before it had time to react. Since risk-savvy traders using leverage would always use a Stop Loss as a kill switch.

Leverage is much more popular in low volatility markets, although Black Swan events can occur and create huge sell-offs, such as the drama of the last two US elections, the outbreak of war, disasters natural or of human origin.

Many people use leverage without even realizing it, as it is the basis of familiar retail lending products, such as residential mortgages.

The vast majority of first-time buyers cannot afford to buy a property in cash. Instead, they put down a deposit on the total cost and the bank offers them a line of credit, with a fixed or floating interest rate.

The down payment to overall loan ratio – aka LTV (Loan to Value) – is a form of leverage, as it allows the home buyer to purchase a property with only a fraction of the total cost. . The difference with a mortgage is that there is an option to fix the interest rate – in other words, to fix the risk. This is similar to Stop Loss, as it sets the cost of your debt in stone.

However, some buyers like to let the interest rate follow the bank loan rate, this can mean much lower repayments when interest rates drop, but also monthly payments can become very expensive if interest rates suddenly begin to climb.

Although interest rates – like exchange rates – are not particularly volatile, a small increase can have a big impact on the monthly cost of repayments.

The Black Swan events can, and do, impact interest rates – find out what happened in the 1970s or George Soros’ attack on the pound – creating a seizure, which is the mortgage equivalent of leveraged liquidations, and correlated with high LTVs.

The point about leverage is that it has practical value – buying a house, trading currencies – but if used the wrong way it can just jump in your face, which brings us to the crypto and its impact on the market.

Crypto is a volatile asset, so it is not clear that traders need leverage to generate significant short-term gain opportunities.

Long-term assets like Bitcoin and Ethereum have produced astronomical gains. Check our Why Crypto page – €1 invested in 2009 would have been worth more than €70 million at the 2021 All Time High.

The problem is that investment with low time preference not suitable for everyone. Many traders look at gains made over a decade and essentially want to realize them overnight, using leverage to condense the period. With x100 you can win or lose in 15 minutes or less which can take a lifetime hodling.

Now, since crypto is about agency, the ability to make your own financial decisions, the leverage is there if you’re willing to take the risk. The problem is that leverage can have what in economics are called negative externalities.

A negative externality is an impact on society at large from the production or consumption of a good or service. Good examples are the environmental impacts of oil consumption or the health impacts of smoking. Bitcoin mining is often cited as having a negative impact on the environment but the externality of leverage is the impact it can have on price, given how margin calls work.

Large market movements can be amplified by leverage, especially on the downside. An external trigger – think China ban, or Elon/Tesla U on Bitcoin – pushes the spot price down, as soon as the price reaches the level at which a large number of leveraged trades are set, forcing additional selling pressure to cover margin calls. The sell-offs trigger and a cascading effect drives the market down by a multiple of the initial trigger. A leveraged stock market capitulation.

This is all happening in real time, giving analysts no opportunity to try and calm down recreational traders who see red candles and head for exits, exaggerating dips and creating a waterfall.

After every big drop, where leverage is seen as the main contributing factor, there are calls to ban excessive leverage. But despite the evidence of massive liquidations – every trader being rekt – as soon as the market finds a bottom, leverage eventually builds up. It’s just too tempting, and of course, in the right hands, very profitable.

The problem is that there are simply too many traders stepping in without knowing what they are doing. Leverage is utterly unforgiving to the inexperienced, devouring newbie traders and spitting them out, with the wider market absorbing the collateral damage.

The alternative – regulation – is just as nasty, so it looks like the crypto market will have to tolerate leverage, despite all its risks, leaving the market in a 22 trap.

The impact of leverage can only be minimized with a less volatile market, but this stability is difficult to achieve due to the amplifying effect of leverage on prices.