Drixx Academy/What is Leverage Trading?/

What is Leverage Trading?

Lawrence Zhou
Drixx Quant
January 26, 2021

Intro

Just as using a physical lever can amplify an input force, trading leverage allows you to amplify a smaller balance into a greater market exposure. This means that you are no longer constrained by the size of your deposit or cash base. Without leverage, if you deposited $1,000, you would only be able to buy $1,000 in risky assets. Leverage allows you to increase this exposure. For example, if your exchange allowed 2x leverage, you could have up to $2,000 in exposure with only $1,000 in deposits.

Being able to "lever up" when necessary is a key tool for any trader. First, it allows you to make larger bets when you have higher conviction. Second, it allows you to amplify smaller moves when the markets are not trending (in say, a scalping strategy). Third (at least in crypto), it can also serve as a form of risk management. How much you can lever is highly dependent on the brokerage and/or exchange you are using. Traditional US brokerages adhering to Regulation T might only allow 2x leverage on equities. Crypto exchanges, however, have been known to allow up to 100x leverage for perpetuals and futures derivative contracts.

In this article, we will investigate how leverage trading in crypto. We will also dive into the benefits and risks of opening a leveraged position.

How can I get levered exposure in the crypto markets?

There are normally two types of leverage trading in crypto: margin trading and derivative trading. Margin trading involves borrowing a base currency (for example Tethers -- USDT) in order to buy the actual crypto asset. Anyone borrowing will typically pay interest to do so. Derivative trading, however, does not involve an exchange of crypto for base currency. Instead, it is a purely a bet on the price of the underlying asset.

Whenever you buy a crypto derivative contract (to get "long" or positive exposure to a coin), someone else in the market has sold "or gone short". Special mechanics in each derivative contract ensure that the price of the derivatives never deviates too far from the price of the underlying crypto asset. The derivatives market is an order of magnitude larger and more liquid (lower price impacts and execution costs) than the margin trading market. It is also the most common way that crypto traders leverage their crypto exposures. As a result, we will be mostly focused on leverage trading in derivatives.

Drixx currently supports both BTC and ETH perpetual contracts at 100x leveraged positions (you can get in-depth details on these contracts by reading the specifications). Try Drixx in action by signing up here.

How does leverage trading with crypto derivatives work?

Crypto derivatives can take many forms. However, the most traded instrument is the perpetual. More than $100 billion dollars notional of these contracts transact daily. This volume and liquidity has led to tight bid-ask spreads and low exchange fees. The contract itself is designed to give you roughly the same level of exposure to the underlying asset (BTC, ETH, etc.) as the dollar notional of the contract. For example, if you purchased $5,000 notional of the BTCUSD perpetual contract, you would make $1,000 if the price if BTC went up 20%.

To better explain how leveraged trading works in crypto, we will be looking at the Drixx BTC perpetual as an example. The Drixx ETH perpetual works similarly, but with ETH as the underlying and deposit currency. In order to trade the Drixx BTC perpetual, you will first need to deposit BTC into your Drixx account (or ETH for the ETH perpetual). Let us assume that BTC is currently trading at $10,000 and you have deposited 1 BTC in the account. How much leverage could you use and what would returns be under different scenarios?

Drixx uses a margin-based leverage system. Currently, the margin on a BTC perpetual is around 1%. This means that you only need to hold 1% of the value of the notional value of your contract. In layman's terms, you can increase your base deposit exposure by an additional 100x. For example: if you had 1 BTC, and it is trading at $10,000, you can get up to $1,010,000 exposure, because $1,000,000 * 1% = $10,000 (so base exposure $10,000 + derivative exposure $1,000,000 = $1,010,000). In general, your account balance + any perpetual profit and loss is known as your margin balance. The leverage ratio, then, is total BTC exposure (derivatives and spot) / margin balance. You can use this ratio to scale your potential returns proportionally. Your returns are just your leverage ratio multiplied by the percentage change in BTC price. If this scaled return is less than -100%, you will lose your entire deposit (liquidated). On Drixx, you will never lose more than your original deposit (brokerages in traditional markets have been known to attempt recovery of negative balances from clients through legal actions).

Going through some examples:

  • If you initially deposit 1 BTC at $10,000 price, then you start at a leverage ratio of 1 (from your 1 BTC). If the price of BTC increases by 10%, then your return will be 10% (or 10% of $10,000 = $1,000).
  • If you initially deposit 1 BTC at $10,000 price, and then buy $20,000 notional of the perpetual, then your leverage is 3 BTC / 1 BTC = 3. If the price of BTC increases by 20%, then your return will be 20% times 3 = 60% (or $6,000.
  • If you initially deposit 1 BTC at $10,000 price, and then buy $50,000 notional of the perpetual. Then your leverage ratio is 6. If the price of BTC decreases by 20%, then your return will be 20% x 6 = -120%. Because you can never lose more than your initial deposit, your losses will be capped at -100% (or -$10,000).

We can look through a few more examples with different leverage ratios (and changes in BTC price). Let us explore 5x, 20x, 100x leverage in various BTC up and down cases:

  • BTC up 10%

  • 5x: 5 x 10% = +50% return. $10,000 becomes $15,000.

  • 20x: 20 x 10% = +200% return. $10,000 becomes $30,000.

  • 100x: 100 x 10% = +1,000% return. $10,000 becomes $110,000.

  • BTC up 20%

  • 5x: 5 x 20% = +100% return. $10,000 becomes $20,000.

  • 20x: 20 x 20% = +400% return. $10,000 becomes $50,000.

  • 100x: 100 x 20% = +2,000% return. $10,000 becomes $210,000.

  • BTC down 10%

  • 5x: 5 x 10% = -50% return. $10,000 becomes $5,000.

  • 20x: Liquidated = -100% return. $10,000 becomes $0.

  • 100x: Liquidated = -100% return. $10,000 becomes $0.

  • BTC down 20%

  • 5x: Liquidated = -100% return. $10,000 becomes $0.

  • 20x: Liquidated = -100% return. $10,000 becomes $0.

  • 100x: Liquidated = -100% return. $10,000 becomes $0.

As you can see, trading crypto with leverage can be extremely lucrative if you happen to be on the right side of the market. However, it can also be risky. If you are heavily levered, the path that the underlying asset moves begins to matter. If you are 10x levered and BTC drops 10% before recovering and going up 10%, you would be liquidated before being able to reap the benefits of the price appreciation. There are many benefits and risks to leverage trading in crypto. We outline them below.

Benefits of Leverage Trading in Crypto

  • Amplify Returns: Leveraged trading allows a trader to increase the returns on their bets. If they have a strong conviction on the path and direction of an asset, they can get multiples of their base return.
  • Returns Non-Trending Markets: During choppy or non-trending markets, there might not be enough opportunity to earn returns with just spot. However, a trader might be able to take advantage of local highs and lows by using additional leverage.
  • Capital Efficiency: Leverage trading with derivatives is basically equivalent to being able to borrow money cheaply to express bets.
  • Risk Management: Crypto is inherently risky and historically rife with exchange hacks. A trader might not want to keep all their coins an exchange. Leverage trading lets a trader hedge or adjust their full crypto exposure against a smaller balance kept at the exchange itself (with the majority in cold storage, for example).
  • High Liquidity and Volume: Crypto derivative liquidity and volume is extremely high, providing a cheaper way to get or hedge exposure.

Risks with Leverage Trading in Crypto

  • Amplified Losses: While leveraged trading can amplify returns, it can also amplify losses. If you are wrong on leverage, you might be liquidated (account balance becomes 0) before you can recover. This means that your trading is now path dependent. You can lose money even if you end up being right in the long run.
  • Fees: Just as you can multiply gains, your fees are also multiplied. While fees are low for crypto derivatives compared to spot, the leverage ratio matters. If you are using 100x leverage, that means your fees are multiplied by 100x too. At 7.5bp (the standard Drixx taker fee), a levered fee is around 7.5% of your initial deposit!
  • Funding: Holding a leveraged derivative position is not free. Depending on market conditions, perpetuals may have "funding" events designed to tie the underlying to the derivative. Normally when buy pressure is high on the derivatives, the "funding" is high as well. Like fees, this funding is amplified by leverage (and can be many percent of your initial deposit).

In summary, leverage trading is an important toolkit in a trader's repertoire. It gives a trader extra flexibility to express their bets and use their capital. However, traders should know the risks and limitations.