Trading bitcoin and cryptocurrencies can be a risky endeavour, but it also presents an opportunity to make significant profit. Many trading platforms such as Binance, Bybit and Bitmex enable users to use leverage which can amplify gains, but also losses. Given the relatively unregulated nature of cryptocurrency, many traders in this space are uninformed about how to use leverage effectively. Leverage is also one of the reasons many inexperienced traders lose money. In this article, we are going to go over what leverage is, and how you can use it to manage risk without getting liquidated.

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Trading Platforms are filled with lots of information. Therefore, it is important to take time to learn features such as leverage and liquidation before placing capital at risk.

What Is Leverage?

Leverage can be thought of as an amount of money that is loaned out for the purpose of a trade. The collateral for this loan is called the initial margin. The initial margin is the amount of your own money that you put up in a trade. For instance, if you use 10x leverage with an initial margin of $100, you are taking a $900 loan to increase your trading position to $1000.

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Adjusting leverage is often made simple by trading platforms. However, users should also carefully consider their position size and how much of their capital is exposed if they lose a trade.

With a larger position size, each trade has the potential to make or lose more money than if you were trading with just the initial margin. For instance, using the example from earlier, if prices move in your desired direction by 5%, you will make a profit of 50% relative to your initial margin – which is $50. However, if prices move against you by 5%, you will lose 50% of your initial margin – which is $50.

You can calculate your potential profits/losses using leverage with this simple formula:

P/L = (initial margin) x (% price movement) x (leverage)

The most important thing to keep in mind with leverage is how much of your initial margin is potentially lost as price moves against your position. Always keep your potential losses to levels which you can manage.

What Is Liquidation?

You may have noticed that it is possible to lose your entire initial margin if the market makes a large enough move against your position. Losing the entirety of your initial margin is called liquidation. This is something you should avoid at all costs since excess fees may be applied when it happens.

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To avoid losing the entirety of your initial margin it is important to keep track of the liquidation price and place a stop loss ahead of it.

To keep track of the percentage move prices, need to go against your position for liquidation to occur, you can use the following formula:

Liquidation % = 100 / (leverage)

For instance, if you use 10x leverage, when price moves against your position by 10% you will become liquidated.

Therefore, when using leverage, it is important to place a stop loss ahead of your liquidation price to minimize losses.

What Is The Best Leverage To Use?

In cryptocurrency, it is common for trading platforms to offer leverage up to 125x. In the crypto community, high leverage is mistakenly seen as gambling and very risky. As with all aspects of trading, it is only risky if you do not do your due diligence to be informed. High leverage is not inherently risky on its own. It only becomes risky when your position size is also too large.

Here is an example of how a trader can use higher leverage and still have lower risk than someone with lower leverage.

Trader A: Trader A has an account size of $10 000. They use an initial margin of $100 and 20x leverage to create a position size of $2000. They place a stop loss 2.5% away from their entry position. In this scenario, the trader could potentially lose $50 in their trade, which is 0.5% of their account.

Trader B: Trader B has an account size of $10 000. They use an initial margin of $5000 and 5x leverage to create a position size of $25 000. They place a stop loss 2.5% away form their entry position. In this scenario, the trader could potentially lose $625 in their trade, which is about 6.25% of their account.

As you can see in the scenario above, Trader A has better risk management in their trade, despite higher leverage. Therefore, there really isn’t a “best leverage” to use since you will need to adjust your position size with the leverage you use.

As a rule of thumb, no matter what amount of leverage you are using, you should only be willing to lose less than 1.5% of your account per trade.

When Does Leverage Matter?

There is one situation where the leverage you use does matter independently of your position size and it has to do with liquidation. Higher leverage means prices must move a smaller % distance before you get liquidated. For instance, with 125x leverage, if prices move against your position by 0.8%, you will get liquidated. Bitcoin and crypto markets are very volatile and there is enough noise for fluctuations of that magnitude to occur frequently.

Therefore, it is essential that your leverage accounts for your trading setup. For example, If your setup requires a 5% stop loss, then you will need to use leverage less than 20x. Otherwise you will be liquidated before prices reach your stop loss.

Risk Management Is All That Matters In Trading

When it comes to trading, your first goal should be to not lose too much money! Only after that should you try to make a profit. Traders with poor risk management will lose too much money when their trading setup does not work. No trading system is perfect and losing streaks are inevitable. Therefore, you must manage risk to be able to survive these drawdown periods and not lose too much capital.

If you are willing to lose no more than 1% of your entire account per trade, you will slowly grow your account if you have a profitable strategy. Too often individuals with good strategies fail because their account gets hit too hard from losing streaks.

Trading is a marathon! Become satisfied with small wins and even smaller losses. In trading, going big often means going home empty handed. Unfortunately, this also means that smaller accounts will not really be able to make the amount of money necessary to pay for life expenses.

People who need money the most and have small accounts end up using high leverage because they imagine what each trade will allow them to potential purchase. This is a dangerous mindset to have in trading. Instead, focus on making small gains to grow your account size.

So, the next time someone says high leverage is gambling, just inform them that position size and risk management matter more!


Summary

  • Leverage is using borrowed capital to increase your trading size and potential profits/losses
  • Liquidation occurs when your losses exceed your initial margin
  • Make sure your stop loss is ahead of the liquidation price
  • Risk management and how much you are willing to lose matters more than the leverage you use
  • Adjust your position size and leverage to lose no more than 1.5% of your total account size per trade
  • Focus on keeping losses small instead of chasing big gains

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