There is a tool to earn faster when investing in cryptocurrencies. It is financial leverage; here, I show you how it works.
Financial leverage is one of the best tools traders and investors have to accelerate the accumulation of profits. If you want to discover how it is used to invest in cryptocurrencies, then you should check this publication.
What is financial leverage?
More than a tool, we can define leverage as a strategy employed by individuals or institutions with which they borrow money to buy an asset. We can simplify by saying that it is a credit. This can certainly increase the potential gains, but at the same magnitude, it also increases the risk of facing significant losses.
- Example 1
We can exemplify how leverage works by using a case from everyday life. Let’s use the example of borrowing money to buy a house. If you do not have enough capital to buy it, you apply for a mortgage, which you must pay in full plus the interest charged by the borrower. If you decide to move and to do so, you need to sell the house, then you now have to pay the mortgage, and if the house sells for less than you paid, you will lose.
- Example 2
Suppose you own $1,000 to buy stocks that cost $100 each. You then have the capital to buy a maximum of 10 shares. However, you decide to borrow $1,000. Now you can buy up to 20 shares, which means you have 1:2 leverage. With that, your potential profit is higher, but there is a higher risk of losing all your capital faster. It is common to see leverage of 1:30, 1:50, and even 1:125 in the cryptocurrency market.
Believe it or not, using the leverage of 1:100 and capital of just $1,000, you can buy almost 2 Bitcoins at today’s price of almost $50,000. However, the risk is incredibly high because your capital would be liquidated with a price drop of just 1%. For this reason, it is not advisable to use all of your available capital to open a leveraged trade. It is common to hear experienced investors recommend a maximum risk per trade of between 1% and 3%.
How to invest in cryptocurrencies using financial leverage?
Using derivative products, you can take advantage of the benefits of financial leverage to invest in cryptocurrencies. The most popular are futures and CFDs. Futures are a contract where the parties commit to buy or sell an underlying asset at a specific price and on a specific future date. It can be bought and sold in a secondary market until maturity. The price is determined by supply and demand. Brokers usually execute an automatic renewal of the contract for an additional cost.
Futures with financial leverage to invest in cryptocurrencies are available in many brokers and exchanges. A contract for difference (CFD) is an agreement in which the buyer must pay the seller the difference between the current value of the underlying asset and its price at the time the contract is created. The most complete and widely used for trading this type of product is Binance. If you opt for cryptocurrency CFDs, one of the best places to trade them is XTB broker.
Advantages and disadvantages of using leverage
Financial leverage is a double-edged tool, hazardous if not handled with caution when investing in cryptocurrencies. However, it can be your best friend if you know the risks involved in using it and create a plan with which you won’t even mind having lost a trade. For this reason, it is worth reviewing the benefits and dangers offered by this exciting tool.
Undoubtedly the most significant advantage of investing with leverage. Having greater buying power makes earning more money with less effort. In addition, it is beneficial for those traders looking to profit from small price fluctuations. For example, if you buy one Ethereum at $2,000, which rises by 10%, you will have earned $200. On the other hand, if you use a leverage of 1:10, you can now buy 10 ETH with the same capital, and with a rise of 10%, you will have earned $2,000.
Increased capital efficiency
As you increase the buying power of your capital, you immediately increase your capital’s efficiency. Just think, if it takes 5 days to generate $100 with unleveraged trades. Then you will need less time to earn that $100 since your capital can be reinvested more times, delivering more frequent results.
Take advantage of even low volatility periods.
It is possible to invest in cryptocurrencies when the behavior is sideways and low volatility and still make good profits if you use leverage. Because when we use this tool, we increase the buying power, then small fluctuations can generate good returns.
Just as profits can increase using leverage, losses increase by the same magnitude. When the trade goes against, we will inevitably see a decrease in capital proportional to the leverage used. For this reason, it is vitally important to use this tool in conjunction with stop losses and a minimum risk per trade. This is called risk management; you can read more about it here.
This tool is just a simple credit; every time you use it, you will be charged additional costs in interest. Whether you win or lose, the costs of borrowing money will be charged directly from your capital.
Another relevant risk, and with this we end, is investing in cryptocurrencies using financial leverage. We expose ourselves to a margin call from the broker/exchange because your capital has fallen below the minimum requirement.
This means that if you do not seek to quickly reach the minimum requirement by making a deposit, then the broker may automatically liquidate your position or even several positions. Also, truncating potential gains or closing out losing positions that could be recovered.