In crypto trading, leverage refers to the use of borrowed funds to increase trading position and potential returns. This is similar to leverage trading in traditional markets such as the forex and stock markets.
Crypto exchanges offer margin trading accounts with the support of leverage trading. Leverage can also be used to trade various crypto derivatives on major crypto platforms. To leverage trade crypto assets, an investor or crypto trader deposits funds in a margin trading account; the fund deposited by the trader or investor is called collateral. Some crypto trading platforms allow traders to borrow up to 100 times their collateral. The required collateral depends on the leverage the trader chooses to use and the total value of the position the trader wants to open. The total value of the position a trader opens is known as the margin.
Leverage is described in terms of ratios such as 1:10 (10x leverage), 1:20 (20x leverage), or 1:100 (100x leverage). A trader with collateral of $50 but wishes to open a position in Bitcoin worth $1,000 can achieve this using 1:20 leverage.
Though leverage trading gives investors extra purchase power, it could also increase the risk of a total loss of capital – known as liquidation. The higher the leverage used, the higher the risk of liquidation if a position doesn't go in the trader's direction. Newbie crypto investors and traders are often discouraged from participating in leverage trades; spot trading is the recommended trading method for beginners.
Leverage trading could become a trap for inexperienced investors and traders who might open more long or short positions to recover losses. This could lead to a downward spiral situation similar to those seen in gambling addiction.
Crypto trading platforms that offer leverage trading have increased efforts to educate users on what leverage trading is, and its potential gains and risks. On popular crypto platforms, visiting the leverage trading platform for the first time, users see links to tutorials and pop-up warnings about the risks associated with leverage trading.
To offer users trading options similar to leverage trading, some crypto exchanges introduced a set of crypto assets known as leverage tokens. These tokens are derivative products and they can be traded directly on the spot market. Leverage tokens track the price movement of an underlying crypto asset and use derivative instruments to magnify its return. Crypto exchange giant Binance introduced its set of leverage tokens which it calls the Binance Leverage Tokens (BLVT). These tokens allow traders to gain exposure to leveraged positions without needing to deposit any collateral. 5x long Ethereum (ETH5L) and 3x Short Bitcoin (BTC3S) are examples of leveraged tokens.
In crypto trading there are several trading options available; the trading mechanism and potential return on investment vary with each trading form. A form of crypto trading could be as simple as having some crypto asset (known as the base currency) on a crypto exchange; then buying the desired crypto asset based on its pair to the base currency. The investor might decide to keep the asset for a while in anticipation of some percentage profit. Some forms of crypto trading provide options that would help the investor mitigate heavy losses in cases where the asset price decreases after purchase.
The popular forms of crypto trading offered by the popular crypto trading platforms are spot trading, margin trading, and futures trading.
Spot trading is the simplest, most common, and beginner-friendly form of cryptocurrency trading. In spot trading, crypto assets are exchanged, settled, and delivered immediately on crypto exchanges. Spot markets are found on centralized exchanges (CEX); however, decentralized exchanges (DEX) also offer spot-like order books powered by smart contracts. On the spot market, the buying and selling prices of the crypto asset are listed on the order book; this helps the investor easily see the demand and available liquidity for an asset at any given time. Trades on crypto spot markets are settled on the ‘spot’ (instantaneously).
In spot trading, an investor can place limit orders, market orders, or stop orders during trades. When an investor places a limit order, the asset to be bought or put up for sale is restricted to the buying price or the selling price chosen by the investor. There is no guarantee that a limit order would be executed. Investors make use of limit orders when they feel they could buy an asset at a lower price or sell an asset at a higher price than the current spot price.
In spot trading, market orders are the fastest to execute. When an investor places a market order, the order executes immediately at the asset’s current best buy or sell prices. Investors typically make use of market orders when they need to execute a trade without delays.
Stop orders add some form of risk aversion to spot trading. In this form of order, a trade is executed based on a condition set by the investor; a stop order is triggered automatically and executes a market buy or sell of an asset when the defined stop condition is met. For example, an order is placed to sell 1 BTC for $25,000 if the price of BTC equals or is above $25,200.
Margin trades are also executed using a spot order book; however, a key difference between margin trading and spot trading is leverage. Margin trading is a lot riskier than spot trading. The potential gains and losses in margin trading are way higher than that of spot trading. The method of execution (leverage) used in margin trading amplifies the potential returns or losses.
Futures trading involves the trade of futures crypto derivatives. Just like traditional derivatives, futures derivatives enable a buyer and a seller to enter into a contract based on the value of an underlying asset; in the case of crypto futures, the underlying asset is a cryptocurrency. When investors purchase a futures contract, they do not own the underlying cryptocurrency; they own a contract under which they agree to buy or sell a particular cryptocurrency at a later date.