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What is leverage? Understand the risks, advantages and disadvantages

Cryptocurrency

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We can summarize leverage in two terms: the glory and ruin of every trader. The concept, in general, is very simple, consists of borrowing money to bet on the high or low of some asset, thus increasing the profit potential of the operation.

Leverage increases potential gains in any market, but it also represents a very high risk if done in excess and irresponsibly. However, it can also be very useful for some portfolio protection operations, known as hedging.

The two main means of leverage are: borrowing money from the bank, or using the mechanisms within the trading platforms, such as renting the asset you want to trade, by paying interest in the period when the position is open.

How does leverage work?

In this text, I will talk about the second leverage alternative: using the mechanisms of the trading platforms themselves. Each platform, in different markets, has its own system, which makes some more risky or safer to use leverage in negotiations.

In general, there are 3 essential mechanisms to understand leverage: margin, called margin and settlement price. They are essential to understand what is also known as "Margin Trading".

Margin

Here you need to deposit a guarantee margin in order to use leverage. This margin can usually be given by depositing money, Treasury Direct bills or the asset you want to trade. With the guarantee, you have the right to leverage up to 50 times your position in some brokerages.

This means that with R $ 2500 it is possible to carry out transactions with up to R $ 125000 in capital. A gain of 1% over R $ 125,000 would generate R $ 1250 in profit. However, if the price of the asset is in the opposite direction of the trade, you could lose the R $ 2500 and the amounts left as margin.

Settlement price

Often, the trade will not go in the direction you want. You may be betting on the high and the price is falling, or vice versa. With this, you will take a loss and, to prevent you from having the negative balance, there is the settlement price.

The settlement price is the price of the asset at which your loss will be equivalent to the margin you deposited as collateral. When the asset price reaches the settlement price, your margin will be consumed and your position will be automatically settled by the broker.

The higher the leverage selected, the greater the risk and the closer the settlement price will be. For example, if I choose 100% leverage, it would just be enough for the price to move close to 1% in the opposite direction of your trade for your position to be liquidated.

In some cases, volatility may be so high and it may happen that the broker is unable to liquidate its position in time. In this case, your account may be negative and you will need to deposit more margin to cover the loss, under penalty of having your name forwarded to SPC / SERASA.

Margin call

However, before liquidating your position, the broker will make a margin call. Where you will be directed to deposit more margin on your position. As a result, your settlement price will be lower and you will be less at risk of having your position liquidated and your margin consumed.

Observing the distance from the settlement price is essential to manage the margin well and avoid settlements and large losses. The greater the loss, the more difficult it will be to recover.

For example: if you have a 50% loss on equity of R $ 1,000, you will need to make a 100% profit to return to the same R $ 1,000. Having small gains is easy, the problem is when a big loss comes, which makes the trader's journey even more difficult.

Advantage of leverage

Many traders use leverage in dollar and mini-index contracts on the Ibovespa, where the price fluctuation is greater, in order to use high leverage to catch small fluctuations and make money from day trade operations.

In addition, with a small capital, it is possible to expose yourself to a large potential profit, facilitating the multiplication of the money invested in profit cases. Some Bitcoin brokers, for example, offer leverage up to 125 times the balance.

That is, with just 1 Bitcoin, you could trade 125 Bitcoins. If you make a 1% profit, you would earn 1.25 Bitcoin, doubling the balance you left margin. However, things are not that easy. Leverage involves a lot of risk. If the price went in the opposite direction of your trade, you would lose your Bitcoin.

Disadvantages

There is no free lunch. Leverage brings many risks to investors. Some of them have already been exposed above: you are subject to loss of the entire balance if you take a very big loss. In some cases, your account balance may be negative if the broker is unable to liquidate your position.

In addition, leverage is not recommended for beginners and does not have a good sense of risk management. It is much more difficult to recover the balance when the account is at a loss.

Leverage can also compromise judgment of strategies if the trader does not have good emotional control, which would further increase the likelihood of loss.

Where can I operate leveraged?

First, it depends a lot on the asset you want to trade. Anyone who wants to trade dollars, Ibovespa and shares can go to traditional market brokers like Clear. However, it is possible to operate both indexes at the EMX brokerage offering Bitcoin and Tether (digital dollar) as collateral.

Who wants to operate cryptocurrencies, can use Binance, which offers leverage in different crypto, including Bitcoin. However, it is recommended to operate only Bitcoin with leverage, as it is the asset with the highest volume. Platforms like Bitmex also offer this type of service.

If you want to use this mechanism, it is recommended to be very careful and not use all your money. Leveraged trade is extremely risky and should only be done with an amount that will be small in the event of a loss. It is recommended to keep cash to increase your margin if necessary.

In what situations do you use leverage?

It is possible to use leverage to boost earnings and buy more assets without necessarily having the money to do so. For example: it's the weekend, Bitcoin is falling and I have 1 BTC in my wallet, I could transfer 0.1 BTC to Bitmex, open a long position of 0.2 BTC.

In practice, I would be buying Bitcoin with more Bitcoin. In such cases, low leverage is very useful to increase your exposure and earnings a little, as long as you have room to avoid unwanted settlements.

It is also possible to use leverage to hedge (hedge) and protect myself from volatility. Suppose you have 1 Bitcoin, you could send 0.5 BTC to Bitmex and open a 1 BTC short using a 2x leverage, thereby locking your balance in $ while the position is open.

Read this text here, where I teach more about this operation.

However, I recommend leverage only for more experienced investors with a bolder investment profile. If you are starting to invest, don't use leverage. Invest gradually, according to your financial capacity.

If you are interested, study well about the asset in which you are investing and understand in detail the leverage mechanism of the brokerage firm you want to use. After all, it is a complex instrument and full of small details that cannot go unnoticed.

* Text written by Lucas Bassotto and originally published by the Investificar website.

Disclaimer - OBN is an informational website which aims to give the latest blockchain related news to the readers. Articles on OBN should not be considered as investment advice. Trading cryptocurrencies is a high-risk investment, every user is advised to consult an expert before making any decisions.