Leverage is an important concept in trading. At the core, leverage means using borrowed funds to increase the potential return of an investment. In other words, put less of your own money but gain more. And so, the term “margin trading” is essentially a strategy that involves leverage.
Let’s dive into the mechanics of leverage. The hypothetical example below shows how it works: what happens when the price does move in the desired direction and when it does not.
You think that Bitcoin price will go up. You hold Euros and use CEX.IO Broker to set up a position where you will benefit from Bitcoin price going up.
Leverage - 1:2
Open BTC Price - €5,000
Since you believe that the price is bound to go up, you want to open LONG Position.
The leverage of 1:2 means that you only need to put up 50% of funds (1:2=50%, which is also called Margin Rate) to open a position. These funds will be locked as collateral for a loan that CEX.IO Broker extends to you.
Your funds as collateral - €2,500
Borrowed funds - €5,000
Note: it’s an interesting nuance that CEX.IO Broker extends you a loan for the entire amount of trade, i.e. €5,000, and not only for the difference between the trade size and your collateral. Why? Because your collateral just sits as a guarantee for the trade and can actually be in some other currency (USD, for example), different from the currency of trade. On that, read more here.
Scenario 1: Price reaches €7,000
You close the position with a gain of €2,000 (€7,000 - €5,000).
The borrowed funds return to CEX.IO Broker. Your collateral of €2,500 is returned to you. So now you have €4,500 (€2,500 + €2,000) in your balance.
That’s a whopping 80% return on your investment: €2,000 / €2,500 = 80%!
Note: this calculation does not include the commissions of CEX.IO Broker.
For comparison, what would your return have been if you haven’t used 1:2 leverage?
With €2,500, you could buy 0.5 BTC (€2,500 / €5,000).
If the price reached €7,000, you would sell your 0.5 BTC for €3,500, i.e. for a €1,000 gain (€3,500 - €2,500). The return on your investment would be 40% (€1,000 / €2,500).
No coincidence that with 1:2 leverage, if the price moves in your direction, the return is 2 times higher than without leverage. That’s the power of using the borrowed funds to increase your gains.
Scenario 2: Price falls down to €3,000
You close the position with a loss of €2,000 (€3,000 - €5,000).
The borrowed funds of €5,000 get covered from €3,000 of BTC sale price and €2,000 of your collateral.
As a result, you have only €500 left in your collateral, which gets returned back to you. In other words, your initial collateral of €2,500 diminishes by the amount of your €2,000 loss.
Note: Again, this calculation does not include the commissions of CEX.IO Broker.
So your negative return on investment is minus 80% (- €2,000 / €2,500 = - 80%)!
For comparison, what would your loss have been if you haven’t used 1:2 leverage?
Again, with €2,500, you could buy 0.5 BTC (€2,500 / €5,000).
If the price reached €3,000, you would sell your 0.5 BTC for €1,500. So your loss would be €1,000 (€1,500 - €2,500). The negative return on your investment would be -40%: -€1,000 / €2,500 = -40%!
Just as leverage amplifies your gains, when the price moves in a favorable direction, it also does the same with your losses. If the price does not move in the direction you wish, your losses are much higher with leverage than without.
Note that the example shows you what happens under the hood for a better understanding of margin trading. In practice, your profit and loss (FPL - floating profit & loss) will reflect the movements of price so you can see how much your balance will grow or diminish if you close a position.
For simplicity, we did not mention Stop Loss and Take Profit order protections. The former ensures that you cap your losses and the latter fixes your profits at specified levels. It can be a prudent practice to use those.
We encourage you to go through an example with different leverage. Take 1:10 leverage and see where you get. For best understanding, also play with a SHORT position, where you bet that the price will go down.
And, if you are confident in your understanding of how leverage works, put your knowledge to practice: