What is Leverage?

Leverage can be a crypto trader’s best friend or their worst enemy. As with any other tool, whether the use of leverage leads to positive or negative outcomes depends on how effectively it is utilized in your trading.

One definition of leverage is described as making something lighter, such as where a lever amplifies the force exerted to make the lifting of a heavy object easier. Similarly, in cryptocurrency trading, leverage refers to the situation where your buying power is multiplied and it’s made easier to get greater exposure to the price fluctuations of a crypto-asset. 

While leverage boosts the profits you can earn, your losses are also amplified. As a result, risk management becomes much more important to prevent large drawdowns in your account. And because of the amplified effect on the swings in your profit & loss with the market’s fluctuations, it’s advised to keep to an absolute maximum of 1x-2x until you have significant experience with leveraged trading. 

How is Leverage Calculated?

In general, we calculate leverage using margin, which refers to the amount of collateral put up for a trade, and the position size:

Leverage = Position Size / Margin

Note the inverse relationship between leverage and margin. For the same position size, the lower the margin, the greater the leverage utilized (and vice versa). 

With perpetual swaps, larger positions can be built than would otherwise be possible thanks to the use of leverage. For example, a deposit of $100 USDC on Perp v2 multiplies your buying power by a factor of 10 and enables you to enter a position size of up to $1,000. To apply 3x leverage, 30% of your maximum buying power would be used to open a position valued at $300 instead. 

If the price of ETH is $2,000, then with just $100 USDC, a trader can use 5x leverage to open a position of 0.25 ETH worth $500. Without leverage, the trader could only get exposure to 0.05 ETH through the spot markets.

Derivatives such as perpetual swaps give you the opportunity to multiply your profits. If the price of ETH rises to $2,500, the profit of a 5x leverage position equals $125 (=$500/4). Now compare to the case where $100 worth of ETH was bought in the spot market with no leverage. The profit would be five times smaller, at just $25. 

The Benefits and Risks of Leverage

Whilst offering the advantage of magnifying a trader’s profits, it’s important to keep in mind that applying leverage can also lead to larger losses if the market moves against your position. The table below illustrates the benefits and risks, which compares two traders who both go long on ETH-USD at the same entry price: $2,000.

Bob takes on a higher leverage of 10x, and while he has the potential to capture higher profits, he’s also exposed to larger losses if ETH-USD falls. Alice is much more conservative and only utilizes 2x. Her unrealized loss for a 5% fall in the price of ETH is just $10 versus $50 for Bob. Alice’s trading account lost 10%, while Bob’s is down 50%. 

Another important takeaway from the table above is that positions with higher leverage have less breathing room, as the liquidation price is closer to the entry price.

Alice’s position is relatively safer, since the price has to fall much further for her to face liquidation, while Bob’s position is liquidated on a drop of ~$80. Unless Bob reduces the leverage by depositing more collateral to increase his margin and/or decreases the position size, he will be liquidated on a much smaller percentage move in the price. 

We’ve now shown why much more care is required with risk management when applying leverage. One of the best risk management practices is to use a stop loss, which sets the maximum loss you’re willing to accept and automatically exits a position before you are liquidated. Because Alice’s position has more breathing room, she can set a stop loss much lower than Bob can. 

In the scenario where the price falls, then eventually rises above their entry price of $2,000, Alice has a greater chance of realizing a profit while limiting her risk with a stop loss order. Bob risks missing out on the profits from what would have been a successful trade, because he may be bankrupted or lose a significant fraction of his account, even if he uses a stop loss. 

What’s the solution for Bob? Be more careful with leverage!

How to Select Leverage? 

As well as considering liquidation prices, margin and position size, the optimal amount of leverage can also be determined by your trading style. 

If you’re a scalp trader opening positions over very short durations, then higher leverage may be justified to magnify your profits using very large positions that capture many, tiny price movements. In contrast, swing traders who hold positions for hours or days at a time tend to use leverage at the lower end of the scale. 

Since a longer-term trader aims to capture bigger percentage moves, the position size they require does not need to be as large as it would be for a scalper. So applying greater leverage can be more suitable over short timeframes, where the trader aims to quickly enter the market and get out with some profits. 

The expected price range over several hours or days is much larger than it is for 5-minute or 15-minute intervals. Given that there’s greater potential for larger fluctuations over an extended period, it’s sensible to use lower leverage for swing trading setups.

Aside from exploring the best ways to decide on the amount of leverage to use, it’s also worth mentioning when its use should be avoided. The job of a trader is to identify and act upon high probability scenarios with favorable risk-reward ratios. To fulfil this role, the likelihood of your trade idea going to plan is perhaps the most important factor in your decision making. So it is best to avoid using leverage in high risk or high uncertainty situations.  

Summary

Leverage is often said to be a double-edged sword. Use it right, and you can boost your profits. Use it incorrectly, however, and you may face massive losses. 

It’s best to view leverage as a tool in your trading arsenal that should be used cautiously, not at every opportunity. The effectiveness of any tool depends on the skill of the person using it, and skill is linked with experience. 

No matter how good your trading strategy is, wielding leverage ineffectively can cause large losses, or even worse, liquidation. The misuse of leverage can even humble some of the smartest people in the room and the wealthiest of crypto whales.

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