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What is Leveraged Trading? Meaning, Working, Benefits and Disadvantages
Leverage Trading is the usage of derivatives in crypto markets to trade for amounts larger than the capital a trader has.
Leverage Trading is the usage of derivatives in crypto markets to trade for amounts larger than the capital a trader has. It is done with borrowed funds from the trading platform. Although the risks are high, leverage trading offers very lucrative rewards and is therefore very popular among traders with limited capital.
Please note that in many places, leveraged trading is also known as margin trading, or margin futures, because you are allowed to trade with a marginal amount of money.
Table of Contents
Definition
Leveraged Trading refers to the usage of borrowed funds to trade for amounts that are much higher than the trader’s capital. They are allowed to trade until their losses do not exceed their capital. However, they can earn as much profit as they can.
Note: Although there is no actual limit on profit earned from a leveraged trade, it is sometimes limited to prevent the insolvency of the exchange. At those times, such a trade is also forcibly liquidated.
Although no real funds are borrowed, the exchange simply allows the trader to continue trading until his initial capital exceeds the losses incurred. Once losses approach the trader’s original capital, the trader is liquidated. This liquidation prevents any insolvency situation.
How does it work?
Leveraged Trading uses derivatives, such as futures and options. Each trade is designated in advance with the amount of leverage it provides. For example, if you are trading with 2x leverage, it means that you can trade for $1000 with a capital of $500. Similarly, if you trade with 100x leverage, you can trade for $1 million with just $10,000 worth of capital.
The losses in a leveraged trade are allowed only to the point where they do not exceed your capital. Taking the example above, if you are trading with $10,000 and 100x leverage, you can trade for a sum of $1 million but can only suffer unrealized losses of up to $10,000. Once your unrealized losses exceed a threshold, the exchange forcibly liquidates the trade.
The same is not done for profits. Here, a $10,000 leveraged trade with 100x leverage can yield even $1 million in profits. However, in rare cases when exchange liquidity is in question, the trade may be liquidated, and this has happened several times in the past.
Types of Leveraged Trading in Crypto
Leveraged Trading always happens with derivatives.
Futures
Futures are contracts where you trade against another trader, with both of you betting against one another. The loss of one turns into the profit of another. If you or the trader against you closes their trade, another trader assumes the position, so the trade appears to continue.
Future options are available for leveraged trades at multiple leverage levels, ranging from 2x to 100x. Although trades upto 1000x are available on some exchanges, they are generally rare.
Options
Options are derivative contracts that allow users to bet on whether the price of a crypto asset will cross a specific level (the strike price). If the price crosses that point, the trader is paid the amount by which the price exceeds that specific level.
Option contracts are intrinsically leveraged, which means they contain leverage by default, say 15x or 20x.
Benefits
Leveraged Trade provides the benefits of trading with high capital, even with a fraction of the cash. This helps you avoid risks by limiting your losses only to the amount of deployed capital. Such trades are very helpful when you are convinced of a high-risk bet but do not want to lose all your capital.
For small traders, leverage enables them to earn profits comparable to those of their larger peers.
Disadvantages
Leveraged Trading is a high risk high reward activity. If undertaken without proper preparation, it can wipe out your capital more often than it generates profits. I have seen several traders lose it all due to greed and the thought that they can be rich in a single day. Below is a trader sharing a similar experience of their own.
Although there have been several cases of rags turned into riches, there are always more examples of failure because of lower preparedness.
What are the Best Practices for Leveraged Trading?
Based on my 10 years of experience as a trader, here are a few lessons that I have learnt the hard way.
- Get Ready to Lose 100% Capital: For a peaceful leveraged trade, it is essential to understand that sometimes you might lose all of your deployed capital in a high-leverage trade, such as a 50x or a 100x trade, because in them, only a small move can result in liquidation.
- Always Trade With Multiple Indicators: Multiple indicators reduce the risk of losses and identify trades where you have a higher chance of success.
- Always Keep a Stoploss: Stoplosses prevent excessive capital drawdowns when trading on low leverage, such as 2x, 10, or even 20x.
- Always Keep a Take Profit: Greed can easily wipe out hard-earned profits. I, too, have incurred losses in leveraged trades in which my profits exceeded 100% of the deployed capital.
- Do Not Trade After a Loss: Revenge trading impairs decision-making and often leads to further losses.
- Do Not Trade on Conviction: Trading on emotions is no less than gambling. Therefore, always use data to trade, not conviction.
Frequently Asked Questions
Is leveraged trading good for beginners?
No, leveraged trading is not recommended for beginners because they are unable to take care of stoploss, take profits, liquidation levels, etc., while on a trade, which then causes the exchange to forcibly liquidate them.
What is the 3-5-7 rule in trading?
The 3-5-7 rule in trading is that you should never lose more than 3% of your capital per trade, never risk more than 5% of what you own, or set up a 7% min profit target. Sometimes it is written as a 7:1 risk-to-reward ratio, but those high ratios are unrealistic; real-life ratios are more like 3:1.
