What is leverage trading in crypto?

Leverage trading allows you to open a larger position than you otherwise would be able to with the funds you have at your disposal. 

In the simplest terms, leverage amplifies the value of your available capital by a predetermined factor, which in turn amplifies any subsequent gains and losses. Traders often use leverage to trade Bitcoin (BTC), Ethereum (ETH) and other digital assets. 

For example, a trader might leverage $100 of Tether (USDT) ten times (10x), to open a $1,000 position, meaning that any profits or losses are similarly multiplied by 10 until the position is closed.

While leverage can result in significant losses, it can also be a valuable tool for managing risk effectively when applied with careful planning and discipline.

Before we dive in, it’s important to understand some of the key terminology related to leverage trading, as this can create some confusion. Take a moment to read and digest the following, and refer back to it if you need to. 

• Leverage refers to the act of multiplying your available capital from a trading platform to increase your position size. While you are not directly borrowing funds in the way you would with a loan, leverage allows you to control a larger position with a smaller amount of capital by amplifying the exposure to price movements of the underlying asset.
• Leverage Ratio reflects the proportion of margin to leverage as a ratio. For example, using 10x leverage, with $1 of margin you can enter a $10 position, hence the Leverage Ratio of 1:10.
• Position Size refers to the notional amount you buy or sell in a long or short position, respectively. Your position size is made up of the initial margin plus the additional funds. 
• Risk per Trade is the amount or percentage of your trading capital that you are prepared to risk on a given trade. It is not the same as position size. You could have a position size with a notional value of $10,000 and only be risking 1% or $100 of your account balance, as described in the example below. 
• Collateral refers to assets (such as cash or cryptocurrency) that a trader pledges or locks up to secure a leveraged position. It acts as security for the amplified funds.
• Liquidation is the forced closure of your position by the trading platform, and occurs when your margin drops below your maintenance margin level (your liquidation price). It is essentially a last resort, used by the platform to ensure that you do not incur losses beyond the funds available to cover the additional capital.
• Equity refers to the total value of a trader's account, specifically their ownership value, including both the initial margin they deposited and any unrealized profits or losses from open positions. If Cross Margin is used, the entire equity—including unrealized profits—can be liquidated to cover losses, as some trading platforms will automatically close profitable positions to retrieve the necessary funds.
• Funding fees are periodic payments made between traders in a perpetual futures contract market to help ensure that the price of the futures contract stays aligned with the spot price of the underlying asset. These fees can reduce your equity over time, which in turn can affect your ability to meet margin requirements and maintain open positions.
• Margin trading is a broader term that refers to the practice of borrowing funds from a platform or broker to trade assets, allowing traders to open positions that are larger than their account balance. The borrowed funds allow the trader to enter trades with the goal of amplifying returns. It's important to note that margin trading and leverage trading are related but distinct concepts—margin refers to the funds used as collateral, while leverage refers to the multiplier effect on position size.
• Margin is the portion of your collateral that is actively used to open and maintain a leveraged position. Essentially, margin is a fraction of the total position size, backed by the collateral you provide. There are typically two ways that you can choose to allocate collateral.
  • Cross Margin usually means your entire balance can be used as collateral (if a platform has a dedicated Derivatives Wallet it’s usually the full balance within that wallet). This would result in your liquidation price being further from your entry, but if the liquidation price is reached, you can lose your entire balance. 
  • Isolated margin uses only a fraction of your collateral, which brings your liquidation price closer to your entry. This option can cap your losses to the specific collateral deployed for the position in question.

In addition, there are two types of margin to be aware of:

• Initial margin is the initial amount of capital required to open a leveraged position. 
• Maintenance margin is the minimum amount of equity a trader must maintain in their account to keep the position open. If the equity falls below this level, a margin call occurs, requiring the trader to add more funds or face liquidation.

To explain how leverage trading works, let’s imagine a scenario where a trader wants to take a leveraged position on Bitcoin (BTC). 

In this example, based on their experience, research and backtesting, the trader believes that Bitcoin will significantly bounce from $50,000. But the trader has a two concerns:

1. As a trader on lower time frames, they want to profit from a small move—specifically from $50,000 to $51,000, a 2% change. In order to make this trade worthwhile, the trader will need to put 100% of their trading capital to work. 
2. The trader is also concerned about counterparty risk. As the saying goes, “Not your keys, not your crypto” - money deposited on trading platforms is not fully under your control, because access to the funds depends on the platform in question. The trader could deposit all of their available trading capital onto the platform, but then it would be at the mercy of the platform's security protocols for the time it resides there. 

Leverage goes some way to solving both of these problems. If we imagine the trader has a bankroll of $10,000, leverage will enable them to trade at the size they want, without needing to deposit more than 3% of their capital onto the platform. This is where leverage ratios come in.

Leverage ratios represent the extent to which a trader can multiply their position. Common leverage ratios in crypto trading range from 2:1 (2x) to as high as 100:1 (100x). The higher the ratio, the more amplified the profits or losses will be. 

In the current example, the trader wants to:

• Take a position that reflects the size of their entire trading capital—in this case, $10,000—without having to deposit that capital onto the trading platform. 

Every trader has numerous options with regards to leverage ratios, and can often tailor it to enter the exact position size they want, between 2x-100x:

With 2x leverage, for every $1 you deposit as collateral, you can control a position worth up to twice that amount. For example, if you deposit $100, you can take a position size of $200. In this case, half of the $200 would come from your own funds (the margin), while the other half reflects the amplification by leverage. 

Collateral refers to the assets you deposit to secure a leveraged position - it’s the capital you put up to secure the position. 

In most cases, traders have the option to pledge fiat currencies like U.S. dollars or a variety of other cryptocurrencies, including Bitcoin (BTC) and Ethereum (ETH).

Some crypto trading platforms like Kraken offer multi-collateral wallets, enabling traders to use multiple digital assets simultaneously for enhanced flexibility. However, it’s worth mentioning that if you pledge part of your crypto portfolio as collateral, you won’t be able to use 100% of its notional value as margin. This is due to the “haircut,” which is a mandatory reduction in value applied to collateralized crypto assets. The purpose of the haircut is to account for some of the additional risk in using a volatile asset as margin. In short, if you want to use crypto assets as collateral, you will have to accept a small haircut in its value before it can be put to work as margin.

Coin-margined contracts are another example that require a particular crypto as collateral. In this instance, any profits or losses are also realized in the same asset.

Returning to our example, the trader leverages $200 fifty times and uses a bracket order to buy 10,000 contracts of Bitcoin (BTC) at $50,000, with a notional value of $10,000. The take profit is $51,000 and the stop-loss is $49,000. Breaking this down further:

• The trader deposited $300 as collateral into their futures account, leaving the rest of their capital ($9,700) on a hardware wallet. This can help to significantly reduce counterparty risk while still enabling them to trade their entire balance. 
• They then selected 50x leverage, meaning they can open a position up to 50x their collateral, which is $15,000. However, the trader is only interested in taking a $10,000 position. 
• The trader opts for cross margin, which will use all of the available collateral to keep the position open, preventing the trade from being liquidated prior to the stop-loss. This does mean that the trader could lose more than $200 if the market moves violently or there is insufficient liquidity. But again, the total potential loss is capped at $300, as this is all that resides in the account. 
• The initial margin is $200 - this is how much of their collateral is required to open the position. In this instance, the initial margin represents 66% of their collateral, because $200 is required when using 50x leverage to open a $10,000 position. If the trader only wanted a position size of $5,000 using 50x leverage, their initial margin would be $50, only using 30% of the collateral. 
• The expected reward to risk ratio for the trade is 1:1. If the price reaches the take profit of $51,000 before it reaches the stop, the trader will realize a gain of $200. If the price reaches the stop of $49,000 before the take-profit, the trader will realize a loss of $200, (before fees and any potential slippage costs). 

The price of Bitcoin dips down to $50,000 and the order is filled. Price fluctuates around $50,000 for some time, and the trader’s equity moves up and down with it. After several rejection candles at $50,000, price finds some momentum to the upside, reaching the take profit within a couple of hours. After fees and funding, the trader realizes a gain of $199.50. 

A leveraged short position is naturally the inverse of a long position with two key differences. 

1. A long position involves using leveraged capital to buy contracts with the aim of hopefully selling them for a greater value. Short selling uses the exact same mechanics described above, but leverages capital to sell contracts, so that they can be sold into the market and bought back at a later date.
    
2. Short positions theoretically have unlimited risk, because an asset can continue increasing in value indefinitely. However, in a long position, the ultimate floor in price is zero, as price cannot go below this value (oil futures, notwithstanding). This means that your risk is capped, even if it is unlikely for a trader to hold a leveraged position to zero.

Hedging is another way that leverage trading can be used to manage risk. Let’s imagine that you own some spot Ethereum (ETH) but are concerned that the market is about to reverse to the downside. Using leverage can help you protect your capital, by opening a short position that matches the size of your spot holdings. 

Any depreciation in the price of spot ETH is offset by the unrealized gains of the leveraged short position. 

For example, imagine you hold 1 ETH in your portfolio, and decide to hedge this 1 ETH at a price of $1,000. The price of ETH then drops to $900, meaning your spot position would be worth $100 less, but your hedge would now be $100 in profit. 

As a result, in real terms, you have protected the capital parked in your spot ETH via the hedge. Naturally, if you were wrong about the market reversing and ETH rallied instead, any increase in the value of your portfolio would be offset by the unrealized loss of the hedge.

While hedging is a useful strategy for preserving the value in a portfolio, as with all leverage trading, it is not without risk and can go wrong. Many large companies use futures markets to hedge commodities for various reasons, but that doesn’t mean that the position will have a favorable outcome. 

Like all trading strategies, hedging requires the same due diligence and research to increase the probability of success. If you are wrong about your decision to hedge, you may end up being worse off than if you did nothing. Also take into consideration the cost of funding, which can make a hedge costly.

The hedge is still a leveraged trade, with the potential for liquidation or significant loss if managed incorrectly. If you take a hedge position with a tight stop, the market could close your hedge before going in your favor, which would be a really unfortunate outcome. 

Leverage tokens offer an alternative to leverage trading, and remove the possibility of liquidation (though not significant losses altogether). 

Rather than putting up collateral for margin, traders can simply buy a token with leverage built into it, effectively buying a spot asset with increased volatility. At some trading platforms, traders can trade leveraged tokens which move three times as much as the spot equivalent. 

For example, if you bought $1,000 worth of a Solana (SOL) 3x leveraged token, and the actual price of Solana went up 10% in a day, this would be reflected as a 30% move in the leveraged equivalent. This is an arguably simpler way to amplify gains (and losses) without using leverage. However, owing to value decay and daily rebalancing, these tokens are not suitable for long term positions. Holding them for extended periods can result in losses even if the market moves in your favor. 

• Risk management: Leverage allows traders to reduce counterparty risk and also cap their risk per trade in line with strict risk management guidelines. This is an immensely valuable feature that cannot be understated. Traders can also use leverage to spread their risk over multiple platforms, reducing the potential impact of being targeted and slippage. 
• Capital efficiency: Leverage allows traders to control large positions with a relatively small amount of capital.
• Hedging: As described above, by taking a short position equal to assets in your portfolio, traders can mitigate the impact of potential downside in the market and preserve capital. 
• Profit from downside: While you can sell assets you own in spot markets to buy them back lower, leverage trading allows traders to profit from downside on assets they don’t own. This creates many more opportunities for traders to take advantage of. 
• Maximize gains: Traders can use leverage to generate outsized returns that would not be possible in spot markets. Once a position starts to generate an unrealized gain, traders are able to use the increase in margin balance to add to the position, which, if the position continues to go in the trader’s favor, will result in a larger overall gain. This process can be repeated to compound returns for as long the position remains open. 

• Potential for ruinous losses: As many traders have experienced, trading with leverage can have severe consequences. In many cases, this may result from a simple, honest mistake, owing to a lack of understanding about how leverage works. This is why it’s important to only use leverage if you have a confident grasp of the underlying mechanisms, and are able to safely manage risk. 
• Complexity: As demonstrated by the list above, there is a certain amount of complexity to leverage trading, and it can take a little while to understand all the moving parts. This makes it more challenging for novice traders and increases the probability of costly errors. In the UK, many traders are not able to access crypto derivatives products since the FCA banned them for retail traders, citing various reasons related to the potential harm they pose.
• Time sensitivity: Because of the way that crypto futures contracts work, traders are both price and time sensitive. They are price sensitive because they naturally need the market to move in their favor to realize any gains. They are time sensitive because of the cost of holding a position in certain conditions. If a trader enters a long position when funding is significantly positive, they will have to pay a fee every few hours to hold the position (when funding is positive, longs pay shorts). These fees can add up, and over a long enough period can significantly dent the profitability of a trade. At a certain point, if the market fails to move in their favor over a long enough period, a trader may be paying so much in funding that they may decide to close the position. Put simply, traders paying outsized funding fees need prices to move in their favor within a reasonable time frame, whereas a trader who simply holds a spot position does not have the same problem. 
• Vulnerability to exploitation: Crypto markets often have sharp, volatile movements that catch many traders offside, forcing them into liquidation. A short squeeze is one example - price rapidly spikes, forcing short sellers to cover. These types of moves tend to occur when futures traders are vulnerable, where putting them under pressure will generate liquidity. Take into account also that crypto trades 24/7, and many traders may be caught off guard when they least expect it. 

If you want to know more about crypto futures trading, Kraken has created a library of useful videos for beginners. 

Used correctly and carefully, leverage may reduce counterparty risk, preserve capital and be a source of new trading opportunities. Used carelessly, leverage can result in swift and significant losses. The important message for any novice trader is not to use leverage unless you are certain you know how it works and how to use it. By taking a series of steps to mitigate potential risks, leverage can be a useful tool.