Leverage trading , also known as on-margin trading, is the process of borrowing money to make an investment. Investors in cryptocurrencies use leverage trading to increase the potential returns of their investments. With leverage trading, traders benefit from margin. Margin is the amount of capital invested in the trade in proportion to the total position held. A trader with $100 can increase their trading position to $10,000, thereby achieving a margin of 1%.
Risks and Rewards
People often misunderstand the risks and rewards in leverage. To better understand leverage, it helps to define it in the context of other types of assets, other than cryptocurrencies. A house purchase , for many requires the use of leverage. Few people purchase their homes with just cash. There is an element of leverage with individuals making deposits (e.g. $30,000 for a mortgage of $200,000). Car purchases also require an element of leverage. A car purchase may make a deposit of $10,000 and pay for the rest of the car, using a loan.
The principle of leverage is to use small sums of money to gain more exposure to an asset. When using leverage in investing or trading, an increase in the price of the asset can result in higher profits for an investor. A loss of the asset value can result in equally high losses. Not only does a trader lose the value of the asset but they also accrue costs of borrowing to make the trade.
Stop Losses in Leverage Trading
Flash crashes are among some of the significant risks related to leveraged trading. There are high risks that trader won’t make the correct prediction on the direction. Individuals who long the market may receive an unpleasant surprise in the form of flash crashes. Stop losses are considered as a safety net, limiting the losses experienced in the market.
Exchanges may offer free stop orders or guaranteed stop loss order, which may cost money. Stop loss orders help to sell that an asset once its price reaches a certain low. It allows traders to exit from the markets in the event of a crash. As the saying goes, “Never catch a falling knife”. Stop loss orders can help make trading more effective.
Many experts advise against the practice of leverage trading in the cryptocurrency sector. The technology enabling stop loss orders cannot always be relied on. In 2017, Ethreum crashed on an exchange. A trader’s large order for Ethereum on the platform did not have a stop loss. The system attempted to sell the Ethereum to different people on the platform. The computer algorithm failed to take into account the effects of the spike in supply on prices. Many individuals with leverage on the platform could have their accounts wiped out by such rapid changes in the price of assets.
While some exchanges in the past ensure that they notify users of the price changes and ways to reduce them, exchanges in recent times, typically only make notifications about liquidation of accounts that must be made. The pace of transactions has speeded up over the years, making it a lot harder to mitigate the risks of flash crashes in the cryptocurrency sector.
Leverage Trading on Exchanges
The leverage trading experience of investors may differ, depending on the exchange that they use. Cryptocurrency exchanges have different rules which traders must be cognisant of. Exchanges are under different forms of pressure, from the cyber security risks to the burgeoning amount of users on their platforms. Without adequate procedures and risk mitigates in place, these platforms can find themselves in a pickle, exposed to unforeseen crashes in prices.
There are many misconceptions about leveraged trading. Many people assume there is only one form of leverage trading. There are different types of leverage trading. Cross margin takes into account the whole account balance of a trader as well as their open positions. This exposes the whole account of a user at risk. It is advisable for beginners to avoid cross leverage trading.
Risk managers consider Isolated trades to be less risky for beginners. With isolated trades, only a proportion of a trader’s account balance is used as margin. The rest of the account balance is not affected by the trades unless the user decides to use their whole account to trade.
One of the benefits of leveraged trading is that counter-party risk can be significantly reduced. Traders only have to deposit a proportion of their trading capital in their trading account. Where losses occur, only part of the trading capital is lost.
Leverage and margin trading is a tool for risk management. It should not be considered as a get rich quick scheme. Most people lose their money in leveraged trading due to the significant risks tied to it. Many experts consider dollar cost averaging to be a safer alternative for cryptocurrency investors, especially beginners.
Edel is an Editor with a decade of print and digital media experience – specializing in Science, Technology, Finance, Entertainment, and Advertising. He is also a stock and cryptocurrency investor. When Edel is not editing or analyzing charts, you can find him with his DIY lightbox taking timelapses of plants.