Cryptocurrencies are one of the most volatile ‘asset’ classes in the world. But what does it mean when an asset is volatile? A volatile asset is one that fluctuates both rapidly and frequently in price over a given period of time. As a result, volatile assets frequently attract a particular type of investor often referred to as a risk seeker. It must be noted, however, that although higher volatility can result in higher returns, it can expose traders to higher degrees of risk.
Cryptocurrencies are one of the most volatile ‘asset’ classes in the world. But what does it mean when an asset is volatile? A volatile asset is one that fluctuates both rapidly and frequently in price over a given period of time. As a result, volatile assets frequently attract a particular type of investor often referred to as a risk seeker. It must be noted, however, that although higher volatility can result in higher returns, it can expose traders to higher degrees of risk.
When it comes to trading, the term volatility stretches beyond that of just the asset class. In fact, the perceived risk of a trade is often correlated to the use and abuse of leverage. More precisely, leverage trading. Although leverage can significantly increase a trader’s winnings during a trade, it can sometimes be a double-edged sword, especially when used improperly and irresponsibly. In such occurrences, losses tend to ramp up quickly, often leaving investors staring at their PNL in disbelief.
In this article, we will briefly explain what leverage trading is and how traders use it. This article can be seen as an introduction for beginners in which this trading technique’s advantages and disadvantages will be discussed.
Margin trading often makes use of perpetual future contracts. These contracts are known as derivatives which derive their value from the underlying asset or cryptocurrency that is being traded. What makes these contracts perpetual is the fact that they can be transacted at any desired time and/or date in the future.
Buying on future agreements with margin occurs when an investor buys an asset (e.g., future contracts) partially with their own money, and partially through borrowed funds (usually from a bank, broker, and/or market-maker). This approach allows one to trade at higher capacities without truly owning the underlying assets that are being traded (only a portion).
Imagine an investor holds 500 $USDT in their margin wallet. Expecting that BTC might retrace to the upside, the investor decides to open a $BTC/$USDT futures long position worth 2,500 $USDT. To reach this amount, the trader opts for a 5x leverage. This 5-to-1 leverage position can be seen as a down payment of 20% of the 2,500 $USDT (500 $USDT) in order to leverage this amount against the remaining externally borrowed sum (in this case 80% or 2,000 $USDT worth of $BTC). Such a process is referred to as ‘buying on margin’ and is the most common way traders trade on exchanges.
If $BTC/$USDT experiences an upward retracement of 20%, the above-discussed 2,500 $USDT long would reciprocate this rise, causing the value of the position to now be 3,000 $USDT. This would benefit the trader as the initial funds they invested would have now officially doubled. Since the trader originally put down 500 $USDT, he/she receives the net difference between the total sum invested and the total current value of the position. This results in a 500 $USDT profit (3,000 $USDT – 2,000 $USDT). In other words, 100% gains were experienced on a mere 20% price appreciation.
As one can imagine, if the total position of 2,500 $USDT goes down by 20%, due to an unforeseen BTC capitulation, the trader will lose his/her position. This is because the position is now worth $2,000. Although -$500 does not seem like a lot compared to the absolute position, the 500 $USDT that was initially invested was also used as collateral. As such, it is now considered lost to the trader. Consequently, the investment is automatically evaporated, and the money is lost.
You cannot lose more money than the amount of collateral you put in. If the position loses more than the collateral amount, the whole position closes. Traders often call this being “liquidated” or “margin called.”
It is indeed possible to use coin-margined leverage. What does this mean? Well, instead of trading using $USDT as collateral, the investor can use BTC, XRP, or any other cryptocurrency to open a position.
Suppose someone opens a long position using XRP as collateral. Then, for whatever reason, the market retraces to the upside causing the XRP price to surge. The benefit of using crypto as collateral in an uptrend is that both the XRP used as collateral and the worth of the lent assets will go up. Consequently, when the investor decides to close his/her trade, he/she has now both earned marginally over his/her XRP trade while simultaneously increasing his/her XRP portfolio value.
As you can imagine, doing this in a short position when the market capitulates is not as fruitful, since the value of the underlying cryptocurrency declines as the trader closes his/her position
In a futures contract, a long position uses leverage to generate a profit via price appreciation. To buy this future long position, said trader needs to purchase and immediately resale said asset from a broker or market-maker to the market in the hopes that price will rise (in fact this can be seen as betting against the sold and repurchased position). Consequently, if the price does go up, the trader will receive the difference in price between the initial price and closing price.
A short position is quite the opposite of a long contract. It is a leverage-using contract that attempts to generate a profit through the expectation of price depreciation – the higher the position is started and the lower the price falls, the higher the profit when the position is closed.
Again, the trader lends an asset (e.g. XRP or USDT) from a broker or market-maker and sells it immediately onto the market at the current price (which might be considered “high”). If the price goes down, the trader repurchases the assets at a lower price and returns them to the broker. This is called short covering. Again, the difference between the selling price and the “buy back” price is the profit for the trader.
Interestingly, both long and short leveraged positions can be used to hedge against market fluctuations which can protect a portfolio. If a trader owns a lot of crypto in their “spot” portfolio (spot = not leveraged), they can open a small short position (if they hold a lot of assets) or a small long (if they hold a lot of FIAT). This will protect their portfolio value against further downside for the former and further upside for the latter.
First and foremost, one of the more significant risks while using leveraged trading is the act of getting liquidated. This is because, as initially proclaimed, the asset class is highly volatile. The major downside of such an occurrence is that one cannot recover from this unless they put in additional funds after the liquidation point has been triggered. Consequently, traders must be highly cautious and know what they are doing if they are to use leveraged positions.
The second most significant risk relates to human emotions. The volatile nature of crypto and rapid price movements can instill a full range of emotions. This can be anything from euphoria (often called FOMO) to regret. This emotional rollercoaster can lead to addiction which should be avoided at all costs! As a matter of fact, it has been speculated that bigger players largely trade on the Fear & Greed Index.
This can be preventable if you create a trading plan beforehand that contains a set of rules you can adhere to. Rules about how much risk you are willing to expose yourself to, how much money you are ‘willing to lose’, how much you want to put in each transaction, and lastly, when you should open a trade.
Although at face value this sounds easy to apply, you must keep in mind that most people tend to lose money while trading with leverage. Trading with leverage and using margin can be profitable when used correctly, however, the risks can be enormous. As the saying goes, high risk, high returns, but people tend to quickly forget about the risk part. Therefore, it is a good idea to get some more insight into how it works and how to use it from different sources across the internet.
Bryan indulges in every bit of crypto-related news and material he can lay his hands on. As such, he often shares his views and advice through the onXRP content platform. He is a firm believer in crypto’s potential in the financial and economic world. With 5 years of experience in investing and trading Bryan brings excellent insights to the table. He is excited to bring much of this knowledge and many of his skills to the onXRP platform.
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