What Is Leverage Trading?
Leverage is the use of debt to purchase an asset being held as an investment. Leverage trading allows an investor to gain more exposure to an investment than they would’ve been able to afford if they had used only their available cash.
Leverage increases both the upside and downside of a position and the returns on an asset. This added volatility increases the risk that an investor faces. The additional risk depends on how levered the investment is. In addition to increased risk, an investor will have to pay the lender for borrowing their money.
When an investor utilizes leverage, a given price increase in their asset will result in greater profits. The same logic applies when the asset decreases in price, which results in the investor realizing greater losses. The amount of leverage is measured by the multiples of exposure relative to the equity provided by the investor.
For example, if an investor had $100 and a share of Apple costs $100, they could buy 1 share without using leverage. Alternatively, that investor could borrow $900 to use as leverage, for a total of $1,000. The investor now has 10x leverage in their Apple investment, allowing them to buy 10 shares as opposed to 1 share.
If the price of Apple increased to $110 the investor would hold $1,100 worth of shares. After repaying their loan of $900 they would be left with $200, $100 of which is profit. Due to leverage, the investor made a 100% return even though the underlying asset only increased by 10%.
However, if the Apple stock price decreased to $90 per share, the investor would only have $900 worth of shares. Since the investment is the collateral for the loan, the investment must be worth enough to pay back the loan. In this scenario, the investor would receive a margin call and be forced to sell all their shares to repay the loan, leaving them with a $100 loss.
Alternatively, the investor could provide additional collateral, but now they are reducing their leverage but increasing their total value at risk.
Why Do Investors Use Leverage?
Investors typically use leverage when they are extremely confident about an investment opportunity. Leverage allows investors to make a large profit very quickly if the price moves in their favor. A successful leveraged trade can make an investor a massive return in a very short time period with relatively low capital requirements.
Since leverage is risky and expensive, it does not work well for a long-term investment strategy. Over time, the fees the borrower must pay will lower the return on their investment. Additionally, If the position stays open for long enough, the investor is very likely to experience a margin call eventually. If the investment faces a margin call, the investor may lose their entire investment.
Leveraged investments typically ignore the long-term investment potential of the asset they are trading. Instead, they aim to capitalize on significant short-term events that will have large impacts on price. For example, a company’s earnings report may move the stock price significantly, creating an opportunity for leveraged investors.
Bitcoin does not have earnings reports, but it does experience similar isolated events. For example, legislation regarding the currency has the potential to move the price rapidly and significantly. Additionally, companies adding support for Bitcoin or billionaires making an investment in the currency could move markets and offer opportunities to leveraged investors.
How Does Leverage Affect Bitcoin Markets?
Leverage is used fairly often by investors in Bitcoin markets. Leverage trading is typically done by investors who are extremely optimistic or believe that market-moving news is about to be announced.
When many investors hold leveraged investments in the same asset it will exacerbate large market moves. If the price goes down, many leveraged investors will receive margin calls at the same time. This forces them to sell in order to close their position and pay back their debt. As they sell the price goes down further, triggering additional margin calls.
At a market level, the existence of leverage makes assets more volatile. Increased volatility hurts Bitcoin’s ability to act as a store of value because its price is less predictable. At an individual level, leverage increases risk and makes it possible that an investment ends up completely worthless.
- Leveraged trading is the use of debt to gain more exposure to an investment.
- Leveraged Bitcoin trading gives investors more upside or downside.
- Leveraged investments can become worthless if they get margin called.
- Bitcoin markets are more volatile because of leveraged positions.