What is Leverage and How Does It Work?
Crypto for Beginners
What is Leverage in Crypto?
Ever heard about leverage? According to Meriam-Webster, it's the action of a lever or the mechanical advantage gained by it, or the use of credit to enhance one's speculative capacity. In the realm of crypto trading, leverage allows traders to utilize funds borrowed from the crypto exchange itself to magnify the size and potential gains/losses in a trading position.
How Does Leverage Work?
In essence, a trader would borrow money from the crypto exchange to engage in trading with funds that exceed the total balance of one's trading account.
When using leverage to trade crypto, a trader/investor would margin the available balance of the trading account, with the expectation that the profits resulting from the success of a trading position will be multiplied; beyond that of what total balance available can naturally bear.
Let's portray this with a simple example:
John has $100 in his wallet. He wants to big on Bitcoin, as he envisions that its value will grow. He chooses to leverage his Buy position by 100 times, essentially meaning that the $100 margined represents a $100,000 investment with the power of leverage.
Leverage: A Fiery Double-edged Sword
When a trader utilizes leverage, he/she witnesses greater returns from the simplest of movements. The higher the leverage, the less price movement is required to make the difference, and this applies to both profits and losses.
To make it simple, a $1 price bump bolstered with a 100x leverage equals $100 profit if the position is closed. Yet, a mere fall of $1 represents a loss of $100 when the trading position is closed.
Make sure to understand the risks associated with leverage before adopting it as part of your trading strategy. While profits can be monumental if things go your way, small price changes in the wrong way can result in outcomes which are detrimental to your capital and trading success.
In a nutshell, leverage exposes traders to the risks & benefits of the financial market, and with great power comes great responsibility, so use leverage wisely and cautiously and you can reap the profits that come with it!