Leverage Ratio: Everything to Know
By Beluga Research September 4, 2023
- A cryptocurrency leverage ratio, expressed as 1:10, 1:20, etc., or alternatively, 10x, 20x, etc, indicates the measure by which an investor wants to amplify their initial investment
- A leverage ratio helps an investor with some capital determine the amount of risk, stress and time they are willing to handle to reach their goal
- An exchange or platform can create specialized pitches geared toward investors with higher leverage ratios
- A investor can increase their leverage ratio with practice and by collecting information from investors with similar leverage ratios
A cryptocurrency leverage ratio, expressed as 1:10, 1:20, etc., or alternatively, 10x, 20x, etc, indicates the measure by which an investor wants to amplify their initial investment. A high leverage ratio is one of 25x or more.
A cryptocurrency can also have a leverage ratio. This is found by dividing the dollar value that is locked in active contracts (open interest) by the amount the exchange holds in reserve. When a cryptocurrency's leverage ratio falls, it is likely that the cryptocurrency will experience less price volatility in the near future.
A Brief History
Investors have utilized leverage ratios for centuries in traditional financial markets. Derivatives and margin trading have helped to formalize leverage ratios in the 20th century. Leverage ratios for cryptocurrencies are usually set by crypto platforms or exchanges. They are subject to regulatory requirements. Higher ratios allow investors to control larger positions with less capital. They increase the potential for significant gains or losses. Educational materials created by platforms and web forums can help new investors learn more about setting leverage ratios.
Leverage Ratio: Everything to Know
A leverage ratio determines an investor's borrowing power. This varies depending on the platform or exchange used. For example, with a 10x leverage ratio, an investor can control a position ten times larger than their initial investment.
When adhering to a leverage ratio, an investor must maintain a certain margin in their trading accounts. Margin is the collateral or initial investment required to open and maintain a leveraged position. If the position's value moves unfavorably, the margin may be depleted. This usually leads to liquidation or a margin call. Then the investor must add more funds to meet the platform's requirements.
A leverage ratio can maximize potential returns by allowing investors to enter more advantageous positions. Then they can profit from market movements. Even a small price change in the desired direction can result in significant gains. For example, with a 5x leverage ratio, a 5% price increase can magnify profits to 25%.
Adhering to a leverage ratio can lead to substantial losses. Say the market moves against a leveraged position. The investor's loss would exceed their initial investment. Investors should use stop-loss orders and develop clear risk management strategies to expose them to less risk.
Here is an example of how leverage ratio works. If an investor has $1,000 and wants to enter a leveraged trade with a ratio of 5:1, they can control a $5,000 position. The investor's capital is $1,000 and the borrowed funds amount to $4,000. If the trade goes well and the position increases by 10%, the investor profits $500, or 10% of $5,000. However, if the trade goes against them and the position decreases by 10%, the investor incurs a loss of $500.
Leverage ratio helps an investor determine their financial goals. This includes the amount of risk and stress the investor is willing to undertake.
Monitoring investors' leverage ratios helps a platform determine how much risk its investors are incurring. This allows the platform to understand and monitor investors' concerns.
Leverage ratio helps a cryptocurrency understand its short-term and long-term directions and goals . The platform can then take measures to further the goals, such as increasing scalability.
Cryptocurrency leverage trading offers high leverage ratios compared to traditional financial markets. Leverage ratios of 100:1 or higher are common in the cryptocurrency market. This may seem attractive for potential gains. Yet it also exposes investors to substantial risks.
Margin is an important aspect of leverage trading. Investors need to deposit collateral, called margin, with the exchange or brokerage to secure the borrowed funds. The required margin depends on the leverage ratio and position size. Higher leverage ratios require a smaller margin percentage. Lower ratios demand a larger margin percentage.
Margin requirements ensure investors have enough funds to cover potential losses. If losses approach or exceed the available margin, the exchange or brokerage may issue a margin call. This requires the investor to deposit additional funds to maintain the required margin. Failing to meet a margin call can lead to the liquidation of the position and further losses. A platform can identify and penalize investors who repeatedly fail to meet margin calls.
Crypto leverage calculator. Exchanges typically provide calculators for investors to understand what amount of currency they need to reach their financial goals.
- Potential for higher returns. High leverage ratios allow traders to control better positions and increase profits if the trade goes well.
- Increased market exposure. With high leverage ratios, investors can have a larger stake in the market and take advantage of small price movements. This can lead to more trading opportunities and higher profits.
- Diversification of trading strategies. Setting a leverage ratio enables investors to enter multiple positions simultaneously. They can diversify their strategies and increase the chances of profitable trades.
- Margin trading benefits. Investors' use of leverage ratios helps them borrow funds and profit from volatile markets.
- Access to larger trading volumes. Leverage ratios enable investors to engage in more trades. This is particularly true in highly liquid markets.
- Magnified losses. Leverage ratios can amplify losses if the trade goes against the investor's position. A loss can be a minor setback or the loss of the entire investment.
- Increased risk of liquidation. When using leverage, investors must be aware of the liquidation price. Unfavorable market movements increase the risk of losing borrowed funds.
- Emotional stress and impulsive decisions. Leverage ratios in trading induce emotional stress and lead to impulsive decision-making. This increases the likelihood of losses. Still, losses typically depend on the investor's experience level, training and knowledge of the cryptocurrency and the crypto ecosystem.
- Interest and fees. Investors are typically charged interest on borrowed funds for leverage. Platforms may impose fees for margin trading services. Such costs reduce profits.
- Limited margin call protection. Margin calls can occur if the account value falls below a certain threshold. Then an investor will require additional funds or position closures. In volatile markets, sudden price fluctuations can trigger margin calls. This leaves investors limited time to react.