Leverage trading: Gateway to bankruptcy and hardcore drugs abuse
Recently the leverage trading has been a huge topic in crypto.
Many people who “made it” preach not using leverage in trading as it will destroy you.
But is it true? Is leverage the hidden evil of financial markets, or are all these tweets just the engagement baits on uneducated followers who tried trading with leverage and ruined their accounts?
Your leverage will destroy you
— Ledger 🇺🇸 (@ledgerstatus) October 21, 2021
The truth is that leverage won’t destroy you; leverage trading is one of the most beneficial things that could happen to the financial markets and give many retail traders a fair chance to compete in the field, which used to be only for the rich.
But there are things you need to be aware of because you can do a lot of damage with leverage trading.
This article aims to clarify what leverage trading is, explain who shouldn’t use it, who should, and how it can be useful for those who use it properly.
If you like this article, read the rest of the blog or join the Tradingriot Bootcamp for a comprehensive video course, access to private discord and regular updates.
Table of Contents
First of all, what is Leverage?
If we are trading with leverage, we are borrowing funds from the exchange.
This means that if you have $1000 in your trading account, but your exchange offers 1:100 leverage, you can open a position up to $100,000.
To make this simple, if you use 1:100 leverage on the asset priced at $100,000 and this asset moves down 1% to $99,000, the exchange will liquidate your whole position as they borrowed you $99,000, and they don’t want to go negative.
Leverage in the traditional markets
Leverage in traditional markets is much higher than in crypto.
The E-mini S&P500 is the most traded futures contract in the world.
That’s just some boomer market that is only up 6.8% from the start of the month, right?
Well, not really.
If you ever decide to trade E-mini S&P500 futures (also known as ES), you will find out a minimum size of 1 contract you can open.
This one contract equals 50 x the current price.
As the market is trading at $4535, the contract value is $226,700.
According to AMP Futures, one of the most popular retail brokers, you currently need $400 in your trading account to open this one contract of ES (during the main trading hours).
This means that the current leverage for day trading ES is 1:556.
Since 1 point move in ES equals $50, it will only take 8 points to liquidate the $400 margin you put to the position.
To put this in perspective, on Friday 22nd of October, the market opened at 9:30 AM (New York time), the market moved 8.5 points in the first 5-minute candle.
So how about forex?
There have been countless times when I have seen something like, “I don’t understand why you trade Forex, which doesn’t even move 1% in a whole week when you can trade crypto instead.”
1:100 leverage in forex is nothing special; the exchanges like ICMarkets, one of the most popular Forex exchanges, offer leverage of 1:500.
Using a 1:500 leverage in forex would mean that to buy one standard lot of EUR/USD, which is valued at $100,000, you only need $200 in your trading account.
Doing that on the 12th of October, where the market moved sharply down 20 pips (1pip = $10), it would take approximately 15 minutes to liquidate your account.
Leverage in crypto
These examples from traditional markets were pretty drastic, right?
Well, things are not getting any better in crypto.
5% move in crypto? Your position with 1:20 leverage just got liquidated.
1% move in crypto? Your position with 1:100 leverage just got liquidated.
If you are trading crypto, you know these moves happen multiple times a day across all the markets.
If you open a position with any broker, you will see a liquidation price for your position.
Depending on the leverage you use, this liquidation price will be closer to your entry price.
Once your liquidation price is hit, it game over, and the broker will close your position, and you will get “liquidated”.
As I’m writing this article during the weekend, liquidation data from Bybt are not so crazy but take a look at them during high volatility events, and you will see how high these numbers can get.
Who should not be using leverage
As you can see, the examples are pretty brutal.
Using high leverage gives you very small room to breathe, and your liquidation price is always peaking close to you.
This is the part where it’s important to mention that if you get liquidated, and lose your trading account, it is not fault of leverage or someone hunting your liquidation price.
If you ever get liquidated, it’s only your fault as you were trading to gamble instead of trading without a proper trading plan and strategy.
Most people hate to admit they don’t actually know what they are doing and much rather blame others for their faults.
Understanding that you don’t know how to trade and that you should be much better off passively investing with a long-only approach or dollar-cost-averaging is completely fine.
If you want to play a long game, using leverage doesn’t make much sense.
Not only because you are putting yourself at the risk of liquidating your account but also because you are paying commissions for carrying your position.
In crypto, this is funding; in forex, it’s called swap and so on.
Although these fees can also be positive, i.e. they are paid to your account, generally, holding a spot makes more sense if you want to be in a long game as you have fundamental beliefs about the asset and want to accumulate as much as you can for the future.
But this is only for investing.
How to trade with leverage without blowing up your account
“Markets are unpredictable, you can buy Bitcoin, and it can go 20% down first, so you get liquidated because of leverage and then it goes up.”
If something like this ever happened to you, your last concern in this situation should be leverage.
Of course, it is easier to blame leverage rather than realizing you are trading without a trading plan or stop-loss.
Trading with stop-loss
If you know how to manage your risk in trading, which is the number one reason that separate those who can stay in this game for the long run from those that blow up their account, you will never have to worry about leverage.
I recently published a long guide about risk management which you should read as well.
This is a classic example of someone who has no idea how to manage risk and enters the market with a gambling attitude.
Compared to someone who enters the market with a pre-defined trading strategy, plan and strict risk management rules.
Capital efficiency
Thanks to leverage, you can do more things in the market.
If you have $50,000 in your account and want to buy 1BTC (which is, for this example, priced at $50,000), you can only buy that 1BTC, and your capital is locked out.
Even if you have a protective stop-loss that takes you out once the market goes $5,000 (10%) again, you can’t do anything else with your money as long as you have this position opened.
If you decide to buy this Bitcoin on margin using 1:10 leverage, you are only required to provide $5,000 for the trade.
Although your liquidation price is the same as your stop-loss price, it doesn’t matter; if you were wrong on the trade idea, your position gets liquidated, and you lose 10% of your account.
The difference is that you still have $45,000 that you are completely free to use for hedging or opening completely different positions.
Counterparty risk
This is something no one talks about in crypto.
Why would they when CEOs of exchanges act as the best friend on Twitter, always happy to respond to messages and work on suggested feedback?
The truth is, exchanges go down, they get hacked, investigated by SEC, or just close and disappear.
Even the ones that are “too big to fall” can do this.
If you have $50,000 to trade with, is it really necessary to send it all to the exchange and be exposed to this counterparty risk?
No, thanks to leverage, you don’t have to do that.
If you decide to risk a fixed % amount for each trade and know the expectancies and fallacies of your strategy, there is no reason to park your whole capital in the exchange.
This will differ for everyone, but I rarely have more than 20% of my trading balance on one exchange.
Since I risk 1% per trade and I know I shouldn’t experience more than 20% of account drawdown, there is no reason for me to have more than 20% of the money on the exchange as I can open larger positions thanks to leverage.
Once again, I am always protected by stop-loss; therefore, I don’t have to be worried about the account getting liquidated.
Conclusion
Leverage is truly a double-edged sword.
It can cause a lot of damage to inexperienced who don’t know what they are doing.
On the other hand, it can benefit those who follow strict risk management rules and don’t deviate from them.
I hope I was able to shed some more light on leverage trading, and you will be able to reference this article to those who will shout on social media how leverage is the new spawn of satan, and it will ruin you and your trading account.
If you want to learn more about trading, make sure to read other articles on the blog and check out the Trading Blueprint.
