Zoom - The Leverage Effect in Margin Trading
By Crypto Nation – 9 September 2020
The technique of margin-trading with leverage is a tool used to increase your investment capital. This riskier technique allows greater gains to be made, but greatly amplifies the risk of loss.
Leverage consists in borrowing funds from the exchange platform on which you are. The platform lends you capital, in line with your initial investment. It is generally possible to invest with leverage on a Long or Short order.
Let us take several examples in order to see the effects of the levers.
I want to invest $ 500 in Bitcoin. If I apply a leverage x10, my investment then becomes $ 5,000.
If the value of Bitcoin increases by 5%, I would earn 5% x 5,000 = $ 250.
Conversely, if the value loses 5%, I would lose $ 250.
Be careful, if at any time the value of the loss becomes equal to the value of the initial investment, and you have no collateral (point discussed later), the position is then liquidated. Your position will be automatically sold, and you will lose your entire investment.
I place $ 500 on Bitcoin with x20 leverage. Bitcoin loses 5% of its value. 20 × 5 = 100%. My position is therefore liquidated, I lost $ 500.
When we talk about collateral in trading, it represents a fund that allows you to get into debt. Let’s take our example n°2, to which we specify to have a collateral of $ 5,000. I will then be able to get into debt 10 times my investment of $ 500 before reaching 0. Bitcoin would therefore have to lose 50% to arrive at liquidation.
Another possibility to try to avoid a liquidation: On certain exchanges, it is possible to reinject funds. This method can save the day, but it is also very risky. Because the principle remains the same, if you end up being liquidated, you will lose all your invested money. That is to say, your initial investment + the capital reinjected.
To calculate the liquidation value, just calculate the inverse of the leverage.
I invest $ 500 in Bitcoin with a leverage x5, so I get a position of $ 2,500. The value of my position will be equal to my initial investment when the decline has been 1/5: 0.2, or 20%.