Leverage is one of the most powerful and dangerous tools any trader can use, especially in crypto. Almost every major crypto trading platform offers leveraged products nowadays. New traders often see leverage as “free money,” but this could not be more false. 

Trading with leverage has many upsides and downsides, and this article does not address all of them. The reason behind writing this article is to address the common misconception that leverage exists only to increase returns on an investment. 

Generally speaking, traders can use leverage to potentially earn a bigger payout from a trade. By borrowing money to add leverage, a trader has an opportunity to take more money from the market than if they had only invested their own capital. But this opportunity causes many traders to miss a more important use for leverage: counterparty risk management. 

The Crypto Leverage Landscape

BitMEX launched in 2014, and was an early pioneer in the leveraged crypto trading space. Clients could trade with up to 1:100 leverage (100x). For some traders, that amount of leverage may seem quaint with newer exchanges now offering up to 1000x leverage. 

With any of these leveraged products, traders could not only amplify their potential profits, but, more importantly, they were able to expose a much smaller percentage of their assets to the trading platform and use leverage to trade as if they were managing their entire portfolio. 

After the MtGox saga in 2014 where the platform lost roughly 850,000 BTC, the entire industry was acutely aware of how dangerous and risky holding assets on an exchange really is. Almost a decade later, those same risks exist today, and FTX was one of the most recent and painful reminders. 

Leverage as Risk Management

Instead of being used as a tool for degenerate risk taking, leverage can be a very effective tool for responsible risk management. 

Crypto traders will always want to participate in these markets, and crypto exchanges will always carry counterparty risks. With leverage, traders can reduce their exposure to potential problems with whatever trading platform they use while still trading with the size they want. For example, a trader with $10,000 in capital could deposit $1,000 and use 10x leverage to trade with a dollar amount equal to their real portfolio without exposing all of their funds to the exchange. 

Just like stop-loss orders, leverage can be used as a great tool for managing risks. Instead of price action risks, the counterparty risks are what leverage can help mitigate. But every trader does not need leverage, just like some traders don’t use stop-loss orders. It can be a great tool if it fits a particular trading style. 

Leverage as Returns Multiplier

Yes, a leveraged trade can yield more profit than the same trade taken without leverage. But leverage is a returns multiplier in both directions. In the same way that it can increase profits, leverage can amplify losses too – this isn’t rocket science, but traders often forget (or ignore) this fact. 

Traders who are keen to use leverage should remember that for every success story of a trader making millions of dollars by using high leverage, there are thousands of people who got wiped out and lost all of their funds. More often than not, this happens very, very quickly.

When trading with leverage, traders should always think of the fact that it will increase losses – and how quickly it can wipe out an account – before thinking about how much money they could make. Taking a 20x leveraged trade, for example, means only a 5% move can wipe out the position. (This doesn’t account for fees, liquidation penalty, and other elements that bring liquidation even closer.) 

For the purpose of this article, assuming that anything higher than 3x is “high leverage.” Consider using “high leverage” only in cases where: 

First, a very high probability setup appears where invalidation is close and the risk is worth taking. But focus on the trade’s probability of success, not on the potentially inflated profit amount from using leverage. If the probability of success is not extremely high, using high leverage is not worth the risk. 

Second, leverage is being used to hedge spot positions, which means the trader is in a neutral position and will not suffer any losses or gain any profits if a directional move happens. But even in this situation, leverage is still risky and liquidation is still a net-negative event almost always. 

Third, Market conditions are primed for more risk taking. Observe market trends and personal trading habits (which should be logged in a journal) for data needed to support the thesis that taking additional risk with leverage is a good idea. Otherwise it’s a coin flip gamble.

But in any case, avoid using leverage for prolonged periods of time. Time brings variance and increases the possibility of market events that can cause liquidation.

Leverage as an Addiction

Use leverage wisely. Leverage is an enabler of greed, and greed is one of the most lethal mistakes any trader can make. So, don’t let greed fueled high leverage trade influence trade ideas, trade management, or trading habits. It is never worth it. 

Abusing leverage can lead to a vicious cycle of losing money, taking more risk to make it back, suffering more losses, adding even more risk to make it back, and so on. This causes traders to spiral out of control and the effects often spill over into their personal lives, not just their trading activity. Crypto is one of the most volatile and risky asset classes – traders should not be eager to compound their risks by abusing leverage. 

Most of the time, crypto market activity is volatile enough to yield substantial returns without ever touching leverage. In situations mentioned earlier in this article, leverage can be a useful tool. But combining crypto volatility with leverage leads to things getting quite mad for an average trader. 

Fear and Greed from Leverage

Leverage is a tool. It can easily feed a trader’s greed and cause them to lose it all. But traders should also not be afraid to understand how and when to use leverage appropriately. Hopefully, this article adequately explained the basics of appropriate uses for leverage. In fact, fear of counterparty risks should motivate traders to explore how they can potentially use leverage to reduce risk instead of focusing on using leverage to add risk. 

Traders should understand the leverage products in the market and evaluate their own systems for ways to integrate leverage if it fits their trading style. With great leverage comes even greater responsibility. 

This article was originally published on the author’s Medium page. It has been revised and expanded into its current version for publication on the CMM trading blog.