Should You Trade with Leverage? When, Why, and How?
Leverage, an evil trickster who whispers in our ear “bet more”, or a useful tool for managing risk?
Leverage is a tool like any other. You know, like an axe. You can chop wood with it and keep your family warm or you can use it to split someone's skull. Either way, the axe has nothing to do with it. It’s the one wielding it that makes it either a tool or a weapon.
As traders we are all tempted to up the ante, to increase the capital we’re playing with. More capital equals more profits, right? There are many ways of going about this.
You can compound your profits and keep adding them to your trading account, thereby growing it consistently. Highly recommended.
You can use other income streams to add to your trading stack. Recommended.
You can open a business and start accepting other people’s money, effectively becoming a sort of “fund”. Or simply borrow money from other people. Not recommended.
You can sell your house and go all in. Not recommended at all (speaking from experience).
You can start trading on an exchange or with a broker that offers leverage, where you can trade with more capital than your available margin. Only if you really know what you’re doing in terms of managing risk.
There are perks and cons to all of these approaches, but for the most part I would stick to rearranging your life in a way where you don’t have to take money out of your trading accounts for longer periods of time, either by having an additional income stream or cutting down on your expenses.
Compounding really is the eighth wonder of the world.
Here’s an example to put things into perspective. If you can somehow achieve just 1% per day profit (33% per month) consistently and compound this for a whole year, well - just look below.
Play with some other scenarios using this calculator and behold the power of compounding!
I’m not saying that it’s easy to be consistently profitable and achieve those kinds of results, but it is possible and it does add up over time. Yes, there are faster ways, but they bring along a whole assortment of additional problems you don’t want to be dealing with. Almost all of them will seriously impair your mentality for example, add enormous stress to your work and inevitably hinder your ability to trade as effectively as you did before.
Full disclosure - I trade using leverage and focus mostly on Bitcoin, because:
I want to keep only a minimal amount of my money on any one exchange at all times, because of third party risk (hacks, exchange issues, bankruptcies).
I like to trade on smaller time frames and therefore trade smaller volatility with a tight invalidation, which enables me to trade with larger positions than my margin.
I am absolutely disciplined with my risk management. My risk, my losses are always predetermined and capped as per my rules. No exceptions.
I focus mainly on trading Bitcoin and don’t have to deal with the additional volatility of alts. I use leverage to compensate for this lack of volatility.
I like to keep my trading accounts denominated in Bitcoin during bull markets and still trade Bitcoin/USD pair by trading futures contracts.
The best reason for using leverage and trading on margin exchanges is to mitigate third party risk!
Throughout history there have been countless examples of third party risk. That is to say, the danger of losing your money because something happened to the exchange, wallet or any other third party that is holding it.
There are a million and one things that can happen, most of them out of your control, even if you take every step in protecting your accounts (passwords, 2FA…).
Your first priority then is to minimize this third party danger and the best way to do this is by having as little money as possible on any one exchange (or hot wallet…).
If you’re investing for longer periods of time, transfer your money off the exchanges and onto cold wallets.
If you need all your money on exchanges, because you want to trade with the whole stack, distribute your money across many exchanges.
Use only reputable, larger exchanges and always keep one eye on them.
Ask yourself - if I lose everything in this exchange or wallet, will I be OK or will I be royally screwed?
Never put yourself in a situation where you can lose all your money - never! Unpredictable, previously unheard of situations do happen and they happen when and where we least expect them. Make sure you can survive them, no matter what.
You really shouldn’t keep more than a maximum of 30% of your money on any single exchange. If you’re managing large amounts, take that down to 10%.
If you are an advanced trader and would like to reduce the amount of your third party risk exposure, trading with leverage is the name of the game, next to diversification between many exchanges. Leverage then becomes a tool for protection, not greed!
Having said that, leveraged trading comes with a myriad of additional dangers and the possibility of liquidation on your whole account if you’re reckless, so it is not something to be attempted until you’ve learned all there is to learn about it and have your emotions under control. If you’re just starting to trade with leverage, start small, because the odds are overwhelming that you will lose the first few accounts!
We’ve all been there, dear friend. Live and learn is the name of the game. Survive in order to thrive! Below are a few liquidation notices from my very own email inbox.
The biggest problem with leverage is the danger of liquidation.
When you’re trading on spot exchanges, buying and selling your crypto currency or tokens, you can survive even a 95% drop, if you wait enough time and are lucky enough that your stock or coin survives the winter. If you’re using leverage, that is not an option!
Just look at some of these numbers, every time there’s a bigger move in the market. This was on a roughly 10% move in Bitcoin.
How trading on margin accounts works is that you supply a margin, a certain amount of collateral, and then the exchange will loan you the additional money.
Traditionally about 3x your margin, but in crypto we’re talking 100x possibility or more. Of course using that amount of leverage is not just gambling, it’s actually throwing your money through a window, because less than a 0.5% move against you will liquidate your whole position. It is therefore nothing more than a marketing tool, something for exchanges to measure their dicks with. “My leverage is larger than yours” type thing.
One of the most often asked questions from newbies is “how much leverage do you use?” But that is the wrong question to ask. In fact, if this is even a question you are pondering, avoid leveraged trading like the plague!
Your trading or investing position must always be determined by your risk management rules.
Leverage is just an internal calculation in relationship to your margin on the account, that’s it! If you have decided to risk a maximum of 1% per every trade, then the whole math will revolve around that number. If you’ve decided on a fixed USD number, for instance 100 USD per every trade, then that will be your determining factor for position sizing.
Always ask yourself, “how much money am I willing to lose if I am wrong on this trade?”
Here’s how you can calculate the size of your trading position based on your risk parameters.
If you decide upon 1% of your trading portfolio, this part is easy.
Simply use this formula: (trading portfolio) x 0.01 = X
Example: 10,000 USD (your trading portfolio) x 0.01 = 100 USD.
You can now risk 100 USD per every trade you open. Simple.
Now you have to calculate the size of the position you can open.
Look at the chart and decide where you will be putting your stop loss or simply, where you will get out of the trade if you’re wrong. Some exchanges will calculate potential loss and profit automatically (Bybit for example), saving you the trouble. For all other cases, use Google spreadsheet or Excel and automate the calculations.
Let’s say that you want to get out the trade 5% below your entry point. This is where you’ll be placing your stop. Now we have two data points, your desired risk 100 USD (or 1% of trading portfolio) and the distance to your stop loss position 0.05 (5%).
To calculate the maximum size of the position you can open, simply use this formula:
(risk per trade) / (distance to stop loss) = y (position size)
In our example that would look like this:
(10,000 x 0.01) / 0.05 = 2,000 USD or simply 100 / 0.05 = 2,000 USD.
You now know that you can open (buy/sell) a 2,000 USD position and with a stop loss 5% below your entry, your loss is contained to 100 USD. It doesn’t hurt to take some fees and possible slippage into account and round that number down.
As we have now calculated the maximum size of any position you can open, the rest is relatively simple. Even when using leverage just make sure that the position you opened, however you got to that number isn’t bigger than 2,000 USD and you’re safe. On most exchanges you don’t have to edit your desired leverage, you just have to enter your desired position size, A.K.A. 2,000 USD in our above case, and the exchange will do the rest.
If you want to mitigate third party risk by only keeping a small part of your portfolio on an exchange, leverage is your best friend.
Let’s say as an example that you have a portfolio of 100,000 USD and you choose to hold 10% = 10,000 USD on your chosen exchange for trading. If you had 100,000 USD on your trading account you would trade with the exact same position sizes that you now play with only 10,000 USD on the account! Nothing more and nothing less.
Here’s three example trades for an easier illustration, assuming the same 1% per trade risk rule (1,000 USD):
Trade number 1
Your stop loss is 0.5% away from your entry. Your position size can now be max 200,000 USD, as your loss, should the price dip 0.5% from your entry will equate 1,000 USD. The leverage used will be 20x.
Trade number 2
Your stop loss is 1% away from your entry. Your position size can now be max 100,000 USD, as your loss, should the price dip 1% from your entry will equate 1,000 USD. The leverage used will be 10x.
Trade number 3
Your stop loss is 10% away from your entry. Your position size can now be max 10,000 USD, as your loss, should the price dip 10% from your entry will equate 1,000 USD. The leverage used will be 1x.
As you can see, you can indeed trade responsibly with leverage as long as you always manage risk and calculate your position sizing based on your risk per trade tolerance.
From the first example you can see that if we are day-trading on some small time frames, we can actually increase our size above our whole portfolio, If we set a hard stop very tightly.
When trading on such small movements, you have to take into account all the fees that you will be paying (maker, taker, funding fees) and you have to be wary of slippage. Especially if you are now playing with larger sums in less liquid markets. They can really add up and ruin even a very profitable strategy.
I would highly advise against trading without managing risk and in the case of using leverage - an actual hard stop. Every time I’ve decided to play it loose with leverage, it ended up badly for me and it cost me a lot of money.
There is one more good use of leverage and that is the ability to add to your winners. But never losers!
If your position is in profit and you intend to hold on to your position for some time, you may choose to add size to your position, thus maintaining the same risk as on the initial trade with a much bigger payout if the trade goes your way. In practice this can prove tricky as you are now raising your average entry price and exposing yourself to a higher risk of getting stopped out.
So what have we learned? Leverage = bad or good? Well, it depends on the user, doesn’t it?
If you use it as a tool for managing third party risk, it can be invaluable. If you use it for gambling as a get rich quick tool, it will be the end of your account.
Here are a few rules I wrote for myself, specifically for leveraged trading, after I’ve been liquidated a few times and have learned the hard way that leverage will not make me rich faster, but may easily make me poor in an instance.
Always manage risk, never open a leveraged position without a hard stop loss!
Never ever remove your hard stop once you’re in a position, you’re not thinking straight, it’s there for a reason!
Never add to losers, only ever add to winners and don’t be greedy!
Your risk defines your position size, always - no exceptions!
Stay safe out there and always manage risk when trading, especially if you’re using leverage.
Disclaimer: nothing here is financial advice, just a fellow trader meditating on his trading journey, sharing the lessons he learned and debating some personal opinions that are only that, opinions and nothing more.
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