Crypto Leverage Trading Explained: Risks, Rewards & Strategy
Some crypto traders want to make profits without tying down too much capital in short-term trades, and one way to do that is through leveraged trading.
Using crypto leverage trading allows them to access funds far greater than their capital, which, in turn, helps them increase their potential profits as quickly as possible.
Although not without risks, an increasing number of traders have adopted it as a preferred strategy. Little wonder that services like Hyperliquid and Aster have quickly emerged as leading platforms in the crypto industry.
This article discusses how leverage trading works, the risks involved, and everything in between.
Main Takeaways:
- Leverage trading allows you to borrow funds and control larger positions, but it increases both profit and the potential for higher losses.
- Collateral and margin determine your leverage – positions can be liquidated if losses exceed your coverage.
- Major risks include funding costs, volatility, margin calls, and platform failures.
- Good risk management is absolutely critical to avoid major losses.
What Leverage Trading Is and How It Works
Leverage trading is a strategy that allows users to control a position larger than their initial deposit. This is possible because the trader gains access to borrowed funds to bolster their market exposure. With this leveraged amount, users can register more gains (or losses) due to increased exposure.
Traders are required to deposit trading capital, known as “collateral,” before they can start using leveraged products. This deposited asset acts as security when they borrow funds to amplify their trading position. From their collateral, the trader allocates a portion to open a position.
This portion is called the margin. Traders can increase their margin to maintain or protect an existing position.
Notably, the margin is always considerably smaller than the total trading position size.
This is because, upon providing margin, the trader can access the leverage ratio feature. This refers to the number of times a trader’s capital is being leveraged.
For instance, a 10x leverage means that the trader multiplies their margin by ten. Simply put, the trader can open a $10 position with a $1 capital.
Since the crypto market is highly volatile, leveraged traders can be liquidated if the price moves against their positions and their collateral is insufficient to maintain their positions. When this happens, the leverage platform will automatically close the position, putting the trader at a loss.
Traders can avoid liquidation by depositing more collateral to boost their existing position and stay above the liquidation level. They can also reduce their position size to avoid liquidation.
Centralized exchanges (CEXs) and decentralized exchanges (DEXs) offer leverage trading, with DEXs typically offering higher leverage than CEXs. This is why many traders prefer these decentralized platforms, as they give them access to more funds.
Types of Leverage Products
Users can trade with leverage through various services. The following is a breakdown of some of the most popular ones:
Perpetual futures
Perpetual futures are a type of derivatives contracts that allow traders to speculate on the price of a cryptocurrency without actually holding the asset. Unlike standard futures, perpetual futures do not have expiration dates. This implies that users can hold a trading position indefinitely, as long as they can meet the margin call (liquidation level). Users can take a long or short position while trading.
Standard futures
Crypto futures are financial contracts serving as an agreement to buy or sell cryptocurrencies at a predetermined price on a specified date. Aside from the expiration date, standard futures have identical properties to perpetual futures. This means that traders can execute long or short trades using leverage.
Margin trading pairs
Margin trading involves using borrowed funds to trade cryptocurrencies. It essentially increases the trader’s buying power. Notably, margin trading is a form of leverage trading. Traders can explore margin trading through different currency pairs such as BTC/USDT and ETH/USDC.
Options with embedded leverage
Options trading is a form of trading in which traders have the right (the option), but not the obligation, to buy (call) or sell (put) a crypto asset at a particular price (strike price) within a set period. Like other forms of derivatives trading, users can trade options with leverage, allowing them to gain exposure to larger positions with small capital.
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Key Risks in Leverage Trading
Leverage trading is undoubtedly a risky way to make money in crypto. Due to its extreme volatility, traders put themselves in positions where they either net meteoric profits or substantial losses. However, identifying the most common risks is vital if traders are to avoid them.
Here are the key risks in leverage trading:
Liquidation and margin calls
Traders face a margin call when market prices go against their leveraged positions. As a result, the exchange on which they trade asks them to either add more funds or close the position(s) since their equity is below the required maintenance margin level. Hence, traders need to closely monitor the margin call to downsize the risk of being liquidated.
Volatility risk
Cryptocurrencies are known to be volatile assets, moving up and down sharply. This volatility is what enables traders to either rake in massive profits or suffer losses within a short timeframe. As a result, traders must bear the risks associated with frequent price volatility.
Funding rate impact
Funding rate refers to the percentage of periodic payments made between traders to ensure that futures prices align with those of spot prices for each cryptocurrency. When the futures prices are higher than spot prices, long traders pay short traders. The reverse is the case when futures prices fall below spot prices.
This can affect traders because funding payments can add to the costs of holding a position, pushing them towards liquidation if the market moves against them.
Platform-specific risk factors
There are several issues that can arise when using crypto platforms that you may have no control over. For example, a security breach that may lead to the loss of funds, critical bugs that can prevent you from opening and closing positions during market volatility, and even bankruptcy.
Potential Rewards and When They Occur
Despite its inherent risks, crypto leverage trading offers traders several potential rewards if the market favours them. Here are some benefits traders can receive from leverage trading:
Amplified exposure
Leverage trading offers traders the luxury of amplifying their exposure to their desired cryptocurrencies. This way, when prices soar, they receive significant profits, pay off the borrowed fund, and pocket the rest. However, it is worth noting that amplified exposure pays the trader when prices move in alignment with their leveraged positions.
Hedging uses
Hedging in crypto trading involves taking a position to counter an existing position. To illustrate, imagine a trader takes a primary position on bitcoin (BTC). Concerned that BTC’s value could drop, affecting the trade, the user decides to take another position that will make a profit if BTC drops. This way, they reduce or eliminate the risks of losing money while trading. It also presents an opportunity to earn whether prices go up or down.
Capital efficiency benefits
With leveraged products, traders do not have to tie up all their capital in short-term trades. Instead, they can access more funds with a small amount of collateral, allowing them to deploy their remaining capital to other trades or uses.
Leverage Trading Costs
There are some important costs associated with leverage trading. Understanding the costs will help traders improve their experience with leveraged products,
Funding payments
Funding payments are fees that long and short traders pay to each other on a periodic basis. Recall that the funding rate is the percentage of periodic amounts traders pay one another to ensure futures and spot prices align. Funding payment is the actual amount being paid.
Trading fees
Crypto leverage trading platforms charge traders fees for each trade executed. These fees include maker/taker fees, commissions, spreads, holding fees, and liquidation fees.
Hidden costs in derivatives markets
It is quite common for derivatives exchanges to charge hidden fees. In some cases, the platform does not notify users about these expenses, which is why they are called hidden costs. These hidden fees include spread cost, auto-deleverage (ADL) events, borrowing Interest (Spot Margin Borrowing on CEXs), network fees, slippage, inactivity fees, and several platform fees.
Core Strategies for Using Leverage Responsibly
While leverage trading in cryptocurrencies is extremely volatile, it can be used responsibly. I strongly encourage you to read our essential trading tips before diving deeper into using leverage.
Here are various strategies that can be adopted to ensure efficient usage:
Position sizing
Position sizing is a risk-management measure traders use to determine how much of their capital to allocate to a position. The trader will consider factors such as risk tolerance and asset volatility when deciding on position sizing. This way, no single trade can result in significant losses relative to the overall portfolio.
Stop-loss placement
Another effective risk-management strategy traders can use to protect their positions is a stop-loss (SL). Traders can set a stop-loss order that instructs the platform to automatically close a portion or an entire position when a trade reaches a particular price. This strategy helps to prevent massive losses and even liquidation.
Risk-reward planning
Before entering a trade, traders can use the Risk-Reward Ratio (RRR) to compare the potential profit with the possible loss. To achieve this, the trader would set an entry price, a stop-loss price, and a target price to take profit. Next, they would calculate the risk-reward ratio to determine whether the potential gain is worth the risk.
Using isolated vs. cross margin
Traders implement an isolated margin when they use only a fraction of their collateral to enter trades. Conversely, cross margin involves the use of the entire collateral to create trading positions. Beginner traders and risk-controlled users opt for isolated margin so that even in the eventuality of a liquidation, only a portion of their capital would be affected. Cross margin is preferred by experienced traders seeking to use their entire balance for leverage or explore hedging strategies.
Common Mistakes Traders Make
As profitable as crypto leverage trading is, there is no denying that some traders have lost part or all of their trading capital for several reasons. That said, here are some common mistakes that can lead to losses.
Overleveraging
In the bid to access more funds and increase their potential profit margin, some traders make the mistake of using leverage far greater than their capital. This mistake can happen due to sheer ignorance or overconfidence in the market. Unfortunately, overleveraging puts traders closer to the liquidation price, which can be catastrophic during severe market volatility. The best way to avoid this mistake is for traders to implement self-discipline and stick to a safe level when trading with leverage.
Misreading funding trends
Crypto analytics platforms help traders to monitor the latest trends on funding rates of the derivatives market. Positive funding rates indicate that the market is bullish, signaling a good time to buy, and vice versa. However, a failure to accurately read the funding trends could cause traders to make a financial decision in opposition to the prevalent market trends at the time.
Ignoring liquidity conditions
As most traders get immersed in their trading activities, they tend to forget to monitor their liquidity conditions. Low liquidity leads to higher slippage. This means orders can fill at worse prices than expected, which may push a position closer to liquidation. This could also happen when traders leave their trading screens to do other things. To fix this, traders should always monitor market charts to avoid sudden liquidations. It is recommended that you close your position or not enter a trade if you know that you won’t be available to monitor the market.
Emotional decision-making
Emotions can get really high, and pretty quickly in the crypto market, whether it’s euphoria or chasing losses. And this can make traders make less effective decisions. Therefore, it is vital that traders exercise self-discipline and stick with their trading plans, downsizing the execution of emotion-driven decisions. Most successful traders are individuals who have learnt to tame their emotions while trading.
Differences Across Exchanges and Platforms
Traders can access leveraged trading through centralized exchanges, such as Binance, OKX, Bybit, and Coinbase, or through decentralized platforms, such as Hyperliquid, Aster, dYdX, and Lighter. Let’s take a look at some of their differences.
Fee structures
Some DEXs charge lower trading fees compared to CEXs. For example, Hyperliquid, one of the most popular DEXs for leverage trading, does not charge gas fees for trading and has maker and taker fees of 0.01% and 0.035%, respectively. These fees are further reduced for traders who hold and stake the platform’s native token, HYPE.
In contrast, Binance, the most popular CEX, has maker and taker fees of at least 0.02% and 0.05%, respectively. Another popular exchange with similar and rather competitive trading fees is BingX, as we outline in our BingX review.
Liquidation engines
Due to the risks of sudden liquidations in the derivatives market, trading platforms use automated mechanisms known as “liquidation engines” to close a position when the margin falls below a certain level.
Recall that higher leverage exposes traders to increased risk of losing their trading capital. Since DEXs offer higher leverage than CEXs, they tend to liquidate traders more quickly, coupled with the fact that they lack features that CEXs rely on, such as insurance funds, partial liquidation mechanisms, and ADL buffers.
Hence, trading on DEXs at their peak leverage exposes traders to a liquidation engine that liquidates them more quickly than CEXs would. As a result, CEXs are a better option for traders who do not want to get liquidated quickly.
Asset availability
Most CEXs employ a strict crypto listing procedure that digital assets must meet before being listed for spot or futures trading. Because of this, it may take some time before some assets become available for traders on CEXs to access. In some cases, cryptocurrencies that are unable to meet the criteria are delisted from crypto exchanges.
When it comes to DEXs, traders have easy and quick access to cryptocurrencies because the listing process is quite straightforward and takes less time.
Collateral choices
Many CEXs, including Binance and Bybit, generally support multi-assets mode, which gives traders the opportunity to choose from a list of assets (such as BTC, ETH, USDT, and USDC) to use as collateral.
However, the same cannot be said for DEXs, as only a few decentralized platforms support multi-asset collateral. Most of the time, traders are stuck with stablecoins or the platform’s native token.
Tools and Metrics for Leverage Traders
When it comes to leverage trading, having access to the right tools and market indicators can make a big difference. Understanding how these tools and metrics work will help improve your decision-making, thus increasing your potential profitability.
Open interest
This is the total positions currently opened by traders in a futures contract. If the open interest is high, it means that there is sufficient liquidity in the market, which can help traders to enter or exit their positions at fair prices. In contrast, a lower open interest means a shortage of liquidity.
Funding rates
Funding rates are a metric that shows the percentage of funding payments. For context, funding payments are periodic payments (typically every 8 hours) that traders exchange between themselves to ensure that futures prices are in accordance with spot prices. When the funding rate is positive, long traders pay short traders, and vice versa. Traders can use the funding rate as a sentiment indicator to ascertain when market participants are heavily interested in long trades, and vice versa.
Order book depth
While the order book shows the total buy and sell orders for a particular trade, order book depth is the total volume of buy and sell orders at different price levels in the order book. That said, a deep order book means that there is a high number of orders, indicating high liquidity in the trade.
On the other hand, when order volume is low, the order book is shallow, and the market lacks sufficient liquidity. The implication is that large trade orders can easily affect the price of the asset.
Volatility indicators
These trading indicators measure the volatility of an asset. In other words, traders can use these metrics to understand how much or how fast the price of a crypto asset moves up or down over a period of time. Using volatility indicators can help traders to set trading parameters such as realistic price targets and stop losses.
Conclusion
Leverage trading is undoubtedly one of the most lucrative ways to earn in the crypto industry. It is also one of the fastest ways to lose your entire capital. Given its underlying risks, it is essential that traders understand how the trading strategy works and how to make the most of it. It is also essential to know various strategies to follow to ensure one trades responsibly. This article highlighted all of these, along with common mistakes traders make. With this information, a beginner or experienced trader can make efficient leveraged trades. At the same time, they are urged to conduct further research to make well-informed financial decisions.
