What's wrong with leveraged crypto trading?

If you’re interested in the dynamics of crypto markets you’ll need to understand how leverage works. Leveraged crypto trading is a technique that enables you to make trades up to 100 times bigger than your capital would normally allow, amplifying both the potential gains and losses. This type of high stakes trading should be reserved for the professional, but given it can also have an impact on price - accentuating movements in both directions - it is important to understand how leveraged trading works, to understand the crypto market.

By far the bulk of trading in trading financial markets is foreign exchange - often abbreviated to forex. Traders will, for example, speculate on the value of the US Dollar relative to the Euro, or British Pound relative to the Swiss Franc.

The daily range of fluctuation in these pairs of established currencies 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 might be very modest returns.

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

In order to place a leveraged trade a trader needs a broker or exchange to essentially extend credit so that they can make amplified trades. That credit is not unconditional however. There has to be some red lines to limit losses, which theoretically are much greater than the trader has at their disposal. 

If all goes well, this a leverages trade produce bigger returns without having to put down a huge capital outlay. Should the trade go in the wrong direction, however, losses are also amplified, and the broker will set a trigger beyond which the credit agreement will not extend.

Understanding those terms and what they mean is crucial to understanding how leverage trading works.

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.

Leverage - The degree to which the exchange will allow you to amplify your Margin, expressed in the form of x2, x5, x10, x100 etc

Margin Ratio - The amount of Margin required by the exchange relative to Position. This is the inverse of the level of Leverage. So x2 leverage means that your Margin Ratio will be 50%. Spot trading essentially has a 100% margin requirement, because to place a Spot trade you need to fully fund the Position from your account balance.

Maximum Position - Your Margin multiplied by the Leverage. So if you place €1,000 into your Margin account and available Leverage is x10, your Maximum Position will be €10,000.

Margin Call - The point at which the exchange will require you to add more funds to your Margin account in order to maintain the Margin Ratio - given the decline in your Position - or lower the amount of Leverage.

Liquidation - When your Margin is automatically sold to cover the losses incurred by your Position.

Long/Short Position - When using leverage and betting that price will go up, you take a Long Position, the opposite is taking a Short Position.

Stop Loss - Setting a level of loss at which the trade is automatically cancelled. Traders would see this as the point which 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.

An example of leverage crypto trading

If you start with €10,000 in your exchange account and made a regular (non leveraged) trade that realised a 10% gain you would make €100 (1,000*0.10) and end up with €10,100, increasing your overall funds by 1% (100/10000)

If the trade realised a 10% loss you would lose €100 and end up with €9,900 or 99% of your starting fund - 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 the Margin, and you’d be able to trade a maximum position of $100,000 as your Margin Ratio would be 10%.

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

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

Let's look at the other side of the coin - the basic outcomes of a 10% decline on a long position trade - highlighting the three scenarios, no leverage, x10 and x100, and their impact

With x100 leverage you would get a Margin Call before your losses hit 10%, requiring more Margin or reducing your leverage, but in reality crypto is so volatile that you could easily be liquidated before you have time to react. Given that risk experienced traders using leverage would always use a Stop Loss as a kill switch.

Leverage is far more popular in markets with low volatility, though Black Swan events can come along and create huge liquidations, such as the drama of the last two US Elections, the outbreak of war, natural or manmade disasters. 

Many people use leverage without even realising it, as it is the basis if familiar retail lending products, like residential mortgages.

Many people use leverage without even realising it, as it is the basis if familiar retail lending products, like residential mortgages.

How mortgages are forms of leveraged debt

The vast majority of first-time house buyers don’t have the resources to buy a property outright in cash. Instead they put down a deposit against the total cost and the bank will offer them a credit line, with a fixed, or floating interest rate. 

The ratio of the deposit to the overall loan - aka LTV (Loan to Value) - is a form of leverage, because it enables the house buyer to purchase a property with just 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 in stone the cost of your debt.

Some buyers however, like to let the interest rate track the banking lending rate, this can mean much lower repayments when interest rates decline but equally, monthly payments can get very expensive if interest rates suddenly start to climb.

Though interest rates - like foreign exchange rates - aren’t particularly volatile, a small increase can have a big impact on the monthly cost of repayments. 

Black Swan events can, and do, impact interest rates - check out what happened in the 1970s or George Soros’ attack on the British Pound - creating foreclosure, which is the mortgage equivalent of leveraged liquidations, and correlated to high LTVs.

Leverage & Crypto Volatility

The point about leverage is that it has practical value - buying a house, trading forex - but if used in the wrong way, it can simply blow in your face, which brings us to crypto and the impact it has on the market.

Crypto is a volatile asset, so there is no obvious need for traders to need leverage to generate opportunities for significant short term gain. 

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

The issue is that low time preference investing doesn’t suit everyone. Many traders look at the gains made over a decade, and essentially want to make them overnight, using leverage to condense the timeframe. With x100 you can make or lose within a 15 minute candle or shorter, what might take a lifetime of hodling.

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

A negative externality is an impact on wider society 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 environmental impact but the externality of leverage is the impact it can have on price, given the way margin calls work.

Big market moves can be amplified by leverage, especially on the way down. Some external trigger - think of the China ban, or Elon/Tesla’s U turn on Bitcoin - pushes spot price down, as soon as price hits the level that a large number of leveraged trades are set, forcing further selling pressure to cover margin calls. Liquidations kick in and a cascade effect drags the market down by a multiple of the original trigger. A leveraged market capitulation.

All this happens in real time giving analysts no opportunity to try and calm recreational traders who see red candles and head for the exits, exaggerating the falls and creating a cascade.

After every big fall, where leverage is considered the biggest contributing factor, there are calls for bans on excessive leverage. But despite the evidence of massive liquidations - every one a trader getting rekt - as soon as the market finds a floor leverage eventually builds back up. It is simply too tempting, and of course, in the right hands, very profitable.

The trouble is, there are just too many traders who jump in without knowing what they are doing. Leverage is completely unforgiving of the inexperienced, eating novice traders up and spitting them out, with the wider market absorbing collateral damage. 

The alternative - regulation - is equally unpalatable, so it seems that the crypto market will have to tolerate leverage, for all its risks, leaving the market in a catch 22.

The impact of leverage can only be minimised with a less volatile market, but that stability is hard to achieve because of the amplifying effect of leverage on price.