What Is Leverage in Trading? A Guide to Trading with Multipliers

In this article from Crypto for Living, we are going to discuss the topic of leverage and how it functions in financial markets.

Leveraged trading is a popular strategy across various financial markets, including forex, stocks, commodities, and cryptocurrency. By using leverage, traders can open larger positions with less initial capital, potentially achieving higher returns. However, just as leverage can generate significant profits, it also comes with high risk. Therefore, a thorough understanding of margin dynamics, careful planning, and robust risk management are essential for success. In this guide, we’ll teach you how to use leverage in trading effectively.

What Is Leverage?

Leverage is a tool that allows traders to borrow funds to open larger trading positions than their own capital would typically allow. Let’s explain it with a simple example:

Imagine you have $100 but want to open a $1,000 position. To do this, you would use 10x leverage. This means you enter the trade with $1,000 ($100 of your own money and $900 borrowed from the exchange). Consequently, any profits or losses are multiplied by 10 until your position is closed. If the trade is profitable, you earn 10 times more than you would have with just your $100. Conversely, if you incur a loss, your loss will also be 10 times greater.

While leverage can lead to substantial losses, it can also be a valuable risk management tool when used with a disciplined and well-planned trading strategy.

Key Terms in Leveraged Trading

As we dive deeper into leverage, you’ll encounter several key terms. Understanding these concepts is crucial before you begin.

Leverage

In short, leverage multiplies your initial capital to increase your position size. It’s important to note that leverage is not a loan in the traditional sense; money is not directly deposited into your account. It simply increases the nominal value of your capital, allowing you to control a larger position with less money.

Leverage Ratio

The leverage ratio indicates how much your capital is being multiplied. It’s expressed as a ratio, such as 5:1, 10:1, 50:1, or 100:1.

For instance, if a broker or exchange offers 10:1 leverage, it means that for every $1 you provide as collateral (margin), you can control a $10 position. It’s as if the exchange lends you the other $9 to make your position ten times larger.

Position Size

Position size refers to the total value of your trade in the market. It is composed of your initial margin (your own funds) plus the borrowed funds (from leverage).

Risk per Trade

Risk per trade is the amount or percentage of your capital that you are willing to lose on a single trade. This is different from your position size. You could have a position with a nominal value of $10,000 but only risk 1% of it. This means you would set your stop-loss to trigger at a $100 loss, closing the trade and protecting the rest of your capital.

Collateral

Collateral refers to the assets, such as cash or cryptocurrency, that you must lock on the platform to secure your leveraged position. This collateral assures the platform that it can recover the funds it has lent you.

Liquidation

When an exchange or trading platform forcibly closes your position, you have been liquidated. This happens when your margin (collateral) falls below the required maintenance margin level or hits the liquidation price set by the exchange. It’s the platform’s last resort to prevent further losses for you and to reclaim the funds it lent.

Equity

Equity is the total value of a trader’s account, including the initial margin (the money the trader deposited) and any unrealized profits or losses from open positions. This value fluctuates with the market and is critical for managing risk and avoiding liquidation.

Funding Fee

Funding fees are periodic payments (usually every 8 hours) exchanged between traders in the perpetual futures market. They are designed to ensure that the price of a futures contract stays close to the asset’s spot price.

• In a bullish market, long positions (buyers) typically outnumber short positions (sellers). To prevent the futures price from drifting too far above the spot price, longs pay a small funding fee to shorts.
• In a bearish market, shorts often outnumber longs. In this case, sellers pay the funding fee to buyers to keep the prices aligned.

Funding fees are usually a very small percentage (e.g., 0.01%), but they can add up if you hold a large or long-term position. Since this fee is deducted from your equity, it’s crucial to monitor funding rates to avoid liquidation.

Margin Trading

Margin trading is a broad term for borrowing funds from a platform or broker to trade assets. While related, “margin” and “leverage” are distinct. Margin is the collateral used to secure the position, whereas leverage is the multiplier effect on that position.

Margin

Margin is the portion of your collateral required to open and maintain a leveraged position. It acts as a safety net to cover potential losses. There are two types:

• Initial Margin: The amount of capital required to open a leveraged position.
• Maintenance Margin: The minimum amount of equity you must maintain in your account to keep a position open. If your equity drops below this level, you’ll receive a margin call, requiring you to add more funds or face liquidation.

There are two ways to allocate this collateral:

1. Cross Margin: Your entire account balance (initial funds + P/L from all open positions) acts as a shared pool of collateral for all your trades. If one position loses, the platform can draw from your entire account balance, including profits from other trades, to cover the loss. This offers flexibility but carries a higher risk, as your entire account could be liquidated.
2. Isolated Margin: You allocate a specific amount of margin to each individual position. If one position incurs a loss, only the margin assigned to that trade is at risk, protecting the rest of your account balance. This method offers lower risk but less flexibility.

How Does Leverage Work?

Let’s walk through a practical scenario. Suppose you want to trade Bitcoin (BTC), and its current price is $50,000. You have $10,000 in trading capital and believe the price is about to make a small upward move.

You face two challenges:

1. To profit from a small price movement (e.g., a 2% increase), you would need to commit your entire $10,000 to make a meaningful profit ($200), which is a small return on your total capital.
2. Depositing 100% of your capital onto an exchange for a single trade is risky, even if the platform is secure.

Leverage helps solve both problems. It allows you to trade your desired volume without needing to deposit more than, say, 3% of your capital onto the exchange. If your prediction is correct and you make a $200 profit on a position opened with $300 of your own money, that’s a 66% return on your deposited capital. Without leverage, that same $200 profit would only be a 2% return on your $10,000. If your prediction is wrong and the price drops 2%, you lose $200, potentially losing your $300 deposit, but the remaining $9,700 of your capital remains safe off the exchange.

Essentially, you only pay a fraction of the trade’s full value, and the exchange lends you the rest. Your total profit or loss is calculated based on the full position size, not just the margin you provided.

How Leverage Ratios Work

Leverage ratios determine your multiplying power. In crypto trading, these ratios typically range from 2:1 to 100:1 (or even higher). The higher the ratio, the greater the potential profit or loss.

Using a higher leverage doesn’t change your position size; it only reduces the amount of collateral (margin) required from you. A common misconception is that higher leverage means bigger profits. In reality, higher leverage means less margin is required, which in turn moves your liquidation price closer to your entry price. This makes your position extremely sensitive to small price fluctuations.

For example, to open a $10,000 position:

• With 10:1 leverage, you need $1,000 as margin.
• With 100:1 leverage, you only need $100 as margin.

A smart trader manages this risk. For instance, you could deposit $300 (3% of your total capital) and use it to open a position. If you use $200 as initial margin, the remaining $100 acts as a buffer to prevent immediate liquidation. In the worst-case scenario, you only lose the $300 you deposited.

Practical Examples

Example of a Leveraged Long Position

Let’s revisit our scenario. You believe Bitcoin will rise from $50,000 to $51,000. You deposit $300 of your $10,000 capital onto an exchange.

You decide to open a $10,000 position with 50:1 leverage. To do this, you only need $200 as initial margin. The remaining $100 in your account serves as a buffer.

You set your take-profit at $51,000 and your stop-loss at $49,000. If the price hits your target, you’ll make approximately $200 in profit (before fees). If it hits your stop-loss, you’ll lose $200. This is a 1:1 risk-to-reward ratio.

Example of a Leveraged Short Position

A short position is the opposite of a long. Here, you speculate that Bitcoin’s price will fall from $50,000. The process is similar, but you borrow Bitcoin from the exchange, sell it, and hope to buy it back at a lower price to repay the loan and pocket the difference.

The two key differences are:

1. Long positions use leverage to buy assets, hoping to sell them at a higher price. Short positions use leverage to sell borrowed assets, hoping to buy them back cheaper.
2. Theoretically, short positions have unlimited risk because an asset’s price can rise indefinitely. Long positions have limited risk because an asset’s price cannot fall below zero.

Advanced Strategies

Hedging

Hedging is a risk management strategy using leveraged trades. Suppose you hold Ethereum (ETH) in your spot wallet and are worried about a potential price drop. You can open a leveraged short position for the same amount of ETH to protect your capital.

If the price of ETH drops, the profit from your short position will offset the loss in your spot holdings. If the price rises, the loss from your short position will be offset by the gains in your spot holdings. While useful, hedging is not risk-free and can be costly due to funding fees.

Leveraged Tokens

Some platforms offer leveraged tokens as an alternative to traditional leveraged trading. These tokens automatically manage leverage and rebalance daily, aiming to provide a multiplied (e.g., 3x) daily return of an underlying asset like Solana (SOL). For example, if SOL’s price increases by 10%, a 3x leveraged token would increase by 30%. They eliminate the risk of liquidation but are not suitable for long-term holding due to value decay from daily rebalancing.

Pros and Cons of Leveraged Trading

Advantages

• Risk Management: By committing only a small portion of your capital, you can limit your total exposure and diversify risk across platforms.
• Capital Efficiency: Control large positions with a relatively small amount of capital.
• Hedging: Protect your portfolio against potential market downturns.
• Profiting from Falling Prices: Earn profits from assets you don’t own by shorting them.
• Maximizing Profits: Amplify returns on successful trades far beyond what’s possible in spot markets.

Disadvantages

• Potential for Devastating Losses: A single mistake can wipe out your entire trading account. It should only be used by experienced traders with a solid understanding of risk management.
• Complexity: Leveraged trading involves complex concepts like margin, liquidation, and funding fees, which can be challenging for beginners.
• Time Sensitivity: The costs of holding a leveraged position (like funding fees) can accumulate over time, pressuring traders to be right about both price and timing.
• Vulnerability to Manipulation: Crypto markets can be volatile. Events like a “short squeeze”—where a rapid price increase forces short-sellers to buy back assets at a loss, pushing the price even higher—can lead to cascading liquidations.

Final Thoughts

Leverage is a powerful tool that can be both tempting for its high profit potential and devastating for its immense risk. It can amplify gains but can just as quickly destroy a trader’s capital. Therefore, you should not use leverage until you have a deep understanding of its mechanics and have mastered risk management. Always remember to set a precise stop-loss and never risk more than you are prepared to lose.

Source: Investing