What is leverage in trading?

Leverage trading is a high-risk/high-reward trading strategy that experienced investors use with the aim of increasing their returns. Generally speaking, leverage trading allows investors to gain exposure that they normally wouldn’t have, however it also entails a high degree of risk. We explain what leverage is, how it works, and what the difference is between regular leverage trading and Bitpanda Leverage.

What is leverage trading?

In finance, the term “leverage” refers to the practice of borrowing funds in order to make an investment. The borrowed money takes the form of debt. While debt is something many of us try to avoid in our everyday lives, investors use leverage in the hopes of increasing their returns on an investment. 

Basically, leverage trading means that the investor can have a trading position that is worth much more than the amount of money they put into the investment (more on trading positions below). The flipside of leverage is that the risk is also increased - in case the investment doesn’t turn out as planned, you could incur losses higher than the amount you invested, i.e. your debt increases. 

How does leverage work?

Profits and losses are calculated based on an investor’s total exposure. Exposure refers to an investor’s potential risk, i.e. how much money they stand to gain or lose from an investment. 

Leverage trading enables investors to trade with more exposure than the amount they invested, i.e. how much they stand to gain (or lose) is worth more than the money they put in. This is usually available in multiples like x2, x5 or x10, meaning an investor’s exposure is double, five times, or ten times the amount of money they initially invested. Doubling one’s exposure could potentially double one’s returns, however if the investment falls through (i.e. if the value of an asset goes in the opposite direction of one’s leverage position) then the losses are also doubled.

Here’s an example: Let’s say you want to buy 10 units of an asset worth $100 per unit. In regular trading, you would have to put in $1,000 in order to be able to get the full 10 units of exposure. With x2 leverage, you would only need to invest $500 in order to get the full $1,000 / 10 units of exposure.

Although beginner investors might find leverage trading appealing for its potentially high rewards, the high risk involved with leverage trading makes it more suitable for experienced traders.

Short position vs. long position

When trading assets, you can take one of two positions: either you think that the value of an asset will go up (long position), or you think that the value of an asset will go down (short position). Maintaining a long position on an asset means that you own an asset expecting its value to increase so you can sell it some time in the future for a profit (first buy low, then sell high). 

A short position is the opposite: here you sell an asset and buy it back in the future (first sell high, then buy low). Taking a short position generally means that you borrow an asset from a broker, sell it immediately, buy it back later at a reduced price, return the assets to your broker, and then keep the difference as a profit. 

Short-selling basically allows you to potentially make money off of borrowed assets or collateral. But making a profit from short-selling only works if the value of the asset decreases over time. This is what makes shorting so risky: If you take a short position on an asset and the value increases, then you could potentially incur a loss far greater than the amount you borrowed or sold the asset for (in addition to trading fees). 

In leverage trading, having a long position or a short position functions in the same way, except that now you can increase your exposure through leverage and buy and sell (and short) an asset even if you don’t own it.

What is margin trading?

Margin trading is a sub-type of leverage trading wherein you borrow money from a broker and use it for trading assets. Brokers usually offer a fixed interest rate on the borrowed money. Trading on margin is only possible through a margin account. When you make profit on leverage trading, you have to pay back the interest and the amount loaned to you by your broker in your margin account.

What are the benefits of leverage trading?

Leverage trading is a high-risk trading strategy that experienced investors use in order to significantly increase their returns. Profits could potentially be larger than they would be without leveraged trading. Taking a short position also allows for hedging-based trading strategies, which protects a trader’s future gains and can limit losses. Leveraged trading also gives investors access to more expensive or exclusive asset types that they normally wouldn’t be able to invest in.

What are the risks of leverage trading?

Leverage trading is a high-risk trading strategy as the potential losses could be just as great as the potential profits. Additionally, leverage trading can be quite complex and requires a lot of research and time from the investor. Leverage trading can also incur additional fees, including contract fees and margin rates.

What is the difference between regular leverage trading and Bitpanda Leverage? 

Bitpanda Leverage allows investors to gain exposure and to take a short or long position on the value of certain cryptocurrencies without owning them. Contrary to regular leverage trading, Bitpanda Leverage doesn’t use the underlying asset (i.e. actual cryptocurrencies) and instead uses contracts for differences, also known as CFDs.

What is a contract for differences (CFD)?

A CFD is a contract between a buyer and a seller stating that the buyer will pay the seller the difference between the opening trade price and the closing trade price of an asset. If the closing price is higher than the opening price, then the seller will pay that profit out to the buyer. 

In regular leverage trading, if the closing price is lower than the opening price, then the buyer will have to pay that difference back to the seller - however: with Bitpanda Leverage, we re-leverage automatically on your behalf to cap your losses at the amount of money you put in, so you can never lose more than you invest. 

How? Bitpanda Leverage contains a margin close out control with a trigger of 50% of the initial margin. This means that your position will be automatically closed if a 50% loss has been incurred. A negative balance control ensures that potential losses of your position are capped at the original amount you invested into Bitpanda Leverage.

Short and long leverage positions with Bitpanda Leverage

Bitpanda Leverage allows you to take either a long or a short position on certain cryptocurrencies at x1 and x2 leverage ratios.  

Example of Bitpanda Leverage short position: Let’s say you want to take a short leverage position on Bitcoin at a 1x ratio. We’ll call it BTC1S. Taking this position means that you expect the price of Bitcoin to go down. If it does go down, let’s say by 10%, then the value of your short leverage position BTC1S will go up 10%. 

Example of Bitpanda Leverage long position: Imagine you take a long position on the price of Ethereum at a 2x ratio. We’ll call it ETH2L. If the price of ETH goes up by 10%, then the value of your ETH2L position will go up by 20%.

The bottom line: Leverage trading, whether with underlying assets or through CFDs, is a high-risk approach to investing and can potentially lead to high losses. It’s important to do your own research and take the time to maintain your trading strategy. Remember to always keep your risk-profile at top of mind when opening a position.

Disclaimer

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when trading in CFDs. You should consider whether you can understand how CFDs work and whether you can afford to take the high risk of losing your money.

Bitpanda Financial Services GmbH, and Bitpanda GmbH of Stella-Klein-Löw-Weg 17, 1020 Vienna, Austria, are licensed and regulated by the Financial Market Authority, Austria, (license number GW5000.970/0006-PGT/2019 and W00861/0001-WAW/2020 respectively).

The present does not constitute investment advice. Past performance is not an indication of future results. 

You should seek advice from an independent and suitably licensed financial advisor and ensure that you have the risk appetite, relevant experience and knowledge before trading. Under no circumstances shall Bitpanda have any liability to any person or entity for (a) any loss or damage in whole or part caused by, resulting from, or relating to any transactions related to CFDs or (b) any direct, indirect, special, consequential or incidental damages whatsoever.