Analogy:
"Cryptocurrency leverage trading is like a game of tug of war. Just like in tug of war, there are two teams, each pulling on opposite ends of a rope. In cryptocurrency leverage trading, there are two traders, one taking a long position and the other taking a short position.
The long trader is like the team pulling on the rope in the direction they want to go. They believe that the price of the cryptocurrency will go up, so they want to profit from that increase in price.
The short trader is like the team pulling on the rope in the opposite direction. They believe that the price of the cryptocurrency will go down, so they want to profit from that decrease in price.
The rope in this analogy represents the cryptocurrency itself. The stronger team (or trader) is able to pull the rope (or price) in their desired direction, while the weaker team (or trader) is unable to do so.
In cryptocurrency leverage trading, leverage is like a weight that is added to one side of the rope. For example, if the long trader is using 10x leverage, it's like adding 10 times their own weight to the rope on their side. This gives them a stronger advantage in the tug of war, allowing them to potentially profit more if they are correct in their prediction that the price will go up. However, leverage also increases the risk of loss if the price moves against them."
Leverage trading, primarily for newbies, can be somehow confusing. However, before developing the need to experiment with leverage, it is essential to understand what it is and how it works. Leverage is a concept unique to a derivatives exchange.
We focus on leverage trading in crypto markets, but the info given is also valid for traditional markets.
What is Leverage in Crypto Trading?
Leverage trading mainly involves using borrowed funds by traders to amplify their buying power. While trading with leverage, you can use an initial deposit as collateral (or margin) to make leveraged trades of larger sizes.
Besides, it amplifies your buying or selling power so you can trade with extra capital than what is in your wallet. There is always the likelihood of you borrowing up to 100 times your account balance, which is highly dependent on the crypto exchange you use.
Leverage is described as a ratio showing how often your initial capital is multiplied. For example, a capital of $100 with a leverage of 10x can get you a buying power of $1,000.
Bear in mind that the higher the leverage, the higher the liquidation risks.
With leverage, you can trade different crypto derivatives., including margin trading, leveraged tokens, and future contracts.
How Does Leverage Trading Work?
Before starting trading through leverage, you must have funds in your trading account. The funds you deposit that is what we call collateral. The collateral needed depends on the leverage you use and the total value of the position you want to open (commonly known as margin).
As such, if you want to invest $1,000 in Ethereum (ETH) with 10x leverage. The margin required would be 1/10 of $1,000; you will need to have $100 in your account as collateral.
Despite the initial margin deposit, you must maintain a margin threshold for your trades.
When the market moves against your position and the margin gets lower than the maintenance threshold, you will need to put more funds into your account to avoid being liquidated. The threshold is also known as the maintenance margin.
By opening a long position, a trader buys a perpetual futures contract expecting the price of a crypto asset to go up. For example, you can open a long position of $1000 with a margin of $100 and 10x leverage. When the price of BTC rises by 10%, you earn a profit of $100 on the trade.
However, when the price drops by 10%, your position will be down by $100, and since your initial collateral was only $100, you will be liquidated. Liquidation occurs when your losses exceed your initial security deposit (also called the margin) you used to open the position.
Similarly, by opening a short position, a trader buys a perpetual futures contract expecting the underlying asset's price to decline in the future.
For example, you can use an initial margin of $100 with 10x leverage to open a position worth $1000. If the price goes down by 10%, you have $100 in unrealized profits. If the price goes up by 10%, you have $100 in losses, and your position will be liquidated.
Final Thoughts
Leverage allows you to start quickly with a lower initial investment and the potential to bring higher profits. Still, leverage combined with market volatility could cause liquidations quickly, especially if you take 100x leverage to trade.
Always trade with caution and evaluate the risks before taking on leveraged trading. You should never trade funds you cannot afford to lose, especially when using leverage.
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