Should you be trading Bitcoin with leverage?
The best way to understand the role of leverage is to think of an ordinary investment portfolio as something flat and loose, as the name implies. Leverage adds a third dimension: credit. What was a loosely held together flat portfolio becomes a tightly knit three dimensional structure in which the equity base has to support the credit used.
George Soros: The Alchemy of Finance
So you heard you could trade Bitcoin with 100x leverage, did you?
You looked around to see how, if you put in this much, and you leverage that much, you could make a killing.
But the text on the page you aren’t looking at has all the details of what could happen if things don’t go your way — words like margin call, liquidation and losses.
Let’s take a look at what trading crypto with leverage is, what you should know before you take the plunge.
Leverage rules are a byproduct of history
Trading with leverage isn’t new. It’s been around for a long time across many different markets. Modern regulations around trading with leverage date back to a significant financial debacle, the crash of 1929.
During the crash, heavily leveraged clients, speculators and brokers, got caught offside as stocks fell. As collateral declined in value, margin deposits were wiped out, and losses exploded. Selling increased the call on these loans, which drove more selling and more pressure on borrowers.
The result of 1929 and the aftermath were comprehensive securities laws in the United States and the establishment of a national regulator. In Canada, the Bank Act of 1934 provided the nation with a central bank while regulation remained a primarily a provincial affair. Today Canadian regulation around trading with leverage across financial products falls under IIROC.
BTC borrows from legacy finance
Leverage is used widely across the entire legacy financial sector. It is used strategically in fund management and various trading strategies. Without leverage, our modern financial markets would not exist.
You can learn about leverage looking at financial markets where cryptocurrency, (ahem), borrowed a number of the concepts. And of course, one cannot look at using leverage to trade Bitcoin without noticing a hint of irony.
After all, Satoshi’s groundbreaking release was a reaction to failing financial markets in 2008, which were heavily influenced in part by excessive leverage.
If you are thinking about trading crypto with leverage, it would be wise to take a closer look at the fine print. In the fine print are the details your eyes glossed over when you saw how much you could make with “one hunned X.”
Margin isn’t leverage
Reading about these leveraged BTC trades, there is the word margin, and there is the word leverage. These are two different things that both apply to the same transaction.
Margin refers to the deposit of cash or some form of crypto, you are required to put into your account. Margin is essentially a security deposit for a transaction in some asset. The margin and the subsequent loan relative to the asset you are buying defines the amount of leverage you are using.
Or put the other way, the amount of leverage you can use in a given transaction tells you how much margin is required and what your loan amount will be.
The cryptocurrency exchange you trade with will tell you whether you can deposit BTC, some other form of crypto, or fiat as margin. Sometimes you can use both.
Margin is fluid
Now, the important thing to remember about this deposit, sometimes called initial margin, is that it isn’t static. Margin is based on a formula, and all of the changes and reasons for those changes in your margin amount are outlined clearly in the fine print on each exchange’s website.
So if the price of the asset you are trading on margin falls (or rises if you are short), you will be required to deposit additional funds. The additional funds are called maintenance, and the call you receive to deposit them is a margin call.
If you don’t post additional funds when you receive a margin call, you will be “liquidated.” While the term sounds a lot like a hangover, it refers to being sold out if you are long, or bought back in, if you are short.
You can have cash and margin accounts
Your crypto margin deposit is placed in a margin account, which is distinct from a “cash” account.
If you trade stocks, you can have a cash account and a margin account for trades and investments on the long side. To trade on the short side, there is only a margin account. In futures, margin is required for every trade, and for options, margin applies to writing or selling naked contracts but not for buying them.
We’ll come back to margin in a second.
Now leverage is simply how much more of an asset you control versus how much you have on deposit. Leverage is the ability to control more of an asset with less of your own money.
How leverage on BTC works
If you want to own 1 BTC at $10,000, you can either buy one for $10,000 in your cash account, or you can buy that Bitcoin in your margin account with 10x leverage and a margin deposit of $1,000. A loan of $9,000 supplies the balance of the transaction in your margin account.
If BTC goes up $1,000 to $11,000, your profit in your cash account is 10%, less any fees.
The margin account, on the other hand, has a profit of 100% minus interest on the loan and any fees after the loan is repaid.
Now I know you were looking at that 100% number and thinking to yourself, that’s enough to buy a tire for a Lambo. And that may be true.
But leverage has a nasty little secret. Remember when I mentioned liquidation?
Liquidation isn’t fun
Here’s the thing, leverage works both ways.
If Bitcoin goes the other way, from $10,000 to $9,000, your cash account is down 10%. But if you are trading on margin with 10:1, your margin deposit is now gone. A decline means your account gets a margin call and a request for additional funds or you will be sold out (or bought in if you are short).
Not only that, when you get sold out, any losses above your $1,000 deposit will be added to your account as a debit. So not only do you lose 100% of your deposit, depending on the volatility, you might lose a lot more.
If you’ve ever watched a margin liquidation in the equity markets before, you don’t want the margin manager handling your Bitcoin liquidation trade in crypto. They blow those positions out without mercy.
Now imagine the impact of a trade liquidation on your account using 100x leverage, on an unregulated exchange, in a volatile Bitcoin market with a downside bias. And you thought the flu was bad!
Check the fine print
If you plan to use leverage to trade Bitcoin, you should be aware of a few essential details.
First, you want to look at the security record and procedures of the exchange. After all, they will be taking custody of either your fiat, BTC or some other asset. You also want to understand how much margin is required and how the maintenance process works.
For example, some exchanges might require margin specifically deposited to your margin account. Some exchanges may allow you to use balances in your other accounts (if you have them) at that exchange as the maintenance without having to transfer funds.
Margin and maintenance calculations have clearly articulated formulas on every exchange’s website, so there should be no surprises.
Leverage varies by exchange for various reasons
You may want to consider what types of assets are required for deposit and if you have the option, whether fiat is better than using BTC in this instance.
Make sure you understand the loan values and their time period. Crypto margin account loans are often charged hourly.
When it comes to the amount of leverage available, this varies with each exchange, type of product, and whether or not the exchange adheres to regulation.
So crypto futures will typically allow for higher leverage than non-futures crypto exchanges. Exchanges that are subject to regulation will also typically have lower leverage rates than exchanges that remain unregulated.
There may be some leverage restrictions based on the size of your account, experience and transaction frequency.
Do you really need all 100x?
The key point to remember is that even when leverage is offered or available, it doesn’t have to be used. And just because you can use up to 100x, doesn’t mean that you should.
Leverage is a fundamental part of certain types of financial assets. It is a crucial feature of commodity futures and currency trading. It has a role in part of options trading. Margin account loans for equities are a valuable source of revenue for brokerage firms. They also generate fees for lending out qualified equities for short sales in margin accounts.
Using leverage for trading Bitcoin is neither good nor bad, but rather a tool that can provide different advantages and disadvantages.
Just remember to read all the print on the page, not just the marketing schtick about how much you can make.
It’s nice to dream about the new car with your profits using 100x leverage. Just make sure you don’t have to sell the old car if that leveraged trade you’re imagining, leaves a smouldering hole in your account.
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Originally published at https://bitvo.com on January 23, 2020.
