Crypto Leverage Trading for Beginners

Introduction

DonAlt and I started writing a detailed, technical document on leverage trading some time ago.

Then we realised nobody would read it. It remains unfinished.

Informed participants already know the things we wanted to outline, while less informed
participants probably wouldn’t bother learning.

This document is a form of compromise.

If you’re reading this, you likely know that you don’t know enough, or a kind-hearted friend sent
it to you knowing that you don’t know enough.

Accordingly, this document is by no means exhaustive or complete. Some concepts are

‘dumbed down’ to make them more accessible. We’re trying to keep it short, sweet, and focused
mostly on leverage and liquidations.

Order types, funding, open interest, and all those things have been omitted for brevity. You can
get a decent grasp of those concepts via Cred’s document here.

This specific document is designed to equip you with the bare basics and maximise the chances
of your survival.

To be clear, most readers probably shouldn’t use leverage (or actively day trade for that matter).

Trading is about edge and risk management, not punting outsized directional bets based on
vague inferences from your favourite Twitter icon’s blasé market commentary.

Nevertheless, this document will try to at the very least save you from yourself.

We’re also partnered with FTX via our TechnicalRoundup YouTube channel and free newsletter.

We mostly talk about their mobile app, which doesn’t offer any leveraged products, but we
assume our audience may wish to explore their leveraged products nonetheless.

Accordingly, the least we could do is to make that risk an informed one as opposed to sending
our audience into the liquidation engine meat grinder.

If you wish to sign-up to FTX, you can choose to do so via this link. It will give you discounted
fees and give us a percentage of your trading volume.
U.S. residents can use FTX US via this link.

Finally, we strongly encourage you to watch Cred’s video on risk management alongside
consulting this document. A lot of nuance about position sizing, stop losses, and other important
parameters are covered there. This document will make much less sense without the video.

What Is Leverage?

Think of leverage as a loan, except the bank is your exchange.

You have $1000.

You want to trade with $1500.

You put up a fraction of $1500 as collateral for the exchange to lend you the full amount.

Leverage is simply how much collateral you put up for a position.

More collateral = more margin = less leverage.

Less collateral = less margin = more leverage.

In essence, it’s taking a loan from an exchange (with varying degrees of collateral) usually to put
on a greater position size than the amount on your account.

Crucially, leverage affects your collateralisation (and therefore your liquidation price), not the
position size itself.

For example, If Bob buys 1000 contracts of BTC/USD perpetual swaps at 2x leverage, and
Katie buys the same 1000 contracts of BTC/USD perpetual swaps at 10x leverage, all else
equal, their gains and losses will mirror each other because it’s the same 1000 contracts long
trade.

The leverage affects the liquidation price of that 1000 contract position, not the PnL.

So whether you’re long 1x or 5x doesn’t matter for the most part. It is the position size that
dictates the PnL.

There’s some nuance here with cross versus isolated margin as well as risk limits, but we’ll
dabble in that later.

What Is Liquidation?

Liquidation is the process by which the exchange forcibly closes your position.
This is as a result of price reaching your liquidation price, which is usually visible for your
positions on the exchange of your choice.

Technically, liquidation occurs when your margin drops below your maintenance margin level.

Colloquially, it’s when you pass a certain threshold of losses with your borrowed money.

If you use lower leverage, you put up more collateral, you have more margin, and your
liquidation price will be further away.

If you use higher leverage, you put up less collateral, you have less margin, and your liquidation
price will be closer.

This is why high leverage trading is often castigated; it requires a very large degree of precision
(which most participants lack, by definition). Even small moves against you cause your position
to be forcibly closed.

So maybe, like, don’t use very high leverage.

Cross Margin vs Isolated Margin

There are two main ways to put up collateral for a position: cross margin and isolated margin.

These mechanisms affect both your liquidation price and the consequences of your liquidation.

Cross margin means that your entire account balance is used as collateral for the position.

The good thing is that this typically results in a lower liquidation price as you need to use less
leverage given that your collateral base is larger (it’s your entire portfolio).

The bad thing is that if you get liquidated on a cross margin position, you lose your entire
account balance.

In other words, the losses in a cross margin liquidation aren’t just limited to the collateral you put
up for that single position. They wipe your entire account.

Isolated margin is basically the opposite.

As the name suggests, isolated margin means that if you get liquidated on a position, those
losses are limited to the collateral you put up for that specific position.
The usual trade off is in play here i.e. isolated margin typically means a smaller collateral base
which means higher leverage (for the same position size) and therefore a liquidation that is
closer to price.

To be clear, this section is mostly informational. It should educate you on what’s at risk should
your position reach your liquidation price.

It’s worth reasserting the obvious: don’t put yourself in a position where you incur a high
probability (or any probability) of being liquidated, in any case.

In most cases you should have protections in place to close your position ahead of your
liquidation price e.g. a stop loss order where or when your idea no longer appears to be valid.

Price Types: Last Traded, Index, Mark

Exchanges will generally let you choose a price reference mechanism for your orders.

This is designed to protect against anomalous wicks and also allow users to be more precise in
setting exchange-specific orders.

Price differences between exchanges are common, therefore having this discretion can be
important.

There are three main types of prices.

Last Traded price is the last traded price of the instrument you’re trading on the exchange itself.

Index price is an average price of the instrument you’re trading, derived from a basket of spot
markets.

Mark price is the price of a future minus the basis.

Generally speaking, using Last Traded price is fine. It also allows you to be more accurate when
you’re charting and setting orders for the instrument that you’re trading.

Using Index price or Mark price can be helpful if the exchange of your choice has a high
frequency of anomalous or outsized wicks you’re trying to avoid, but that has become
increasingly rare and exchanges quite often compensate users affected by those moves.

Liquidation is typically dictated by Mark price.

Coin-Margined Liquidations
The examples thus far have assumed that you’re using USD as the collateral for your
positioning.

These linear futures make it very easy to calculate PnL, margin requirements, and so on
because the value of your collateral (USD) remains fixed.

While these linear futures are the dominant form of futures trading, USD collateral is not
applicable to all products.

Some products are coin-margined i.e. your collateral for the position is denominated not in USD,
but in a specific cryptocurrency e.g. trading BTC/USD with BTC as your collateral for the
position.

While this idea may seem attractive on its face, it introduces an additional vector of risk given
the value of your collateral is prone to fluctuate. There is a specific risk that arises when you’re
using these instruments to speculate on the long side of the market.

For example, suppose you buy 1000 contracts of a coin-margined BTC/USD product. You put
up your collateral for the position in BTC. The price of BTC/USD goes down. In this scenario,
not only are you losing money on your position by virtue of being wrong, but you are also
bringing your liquidation price closer as the value of your collateral (BTC) has decreased.

So you’re getting doubly fucked: you’re losing money on the trade and bringing your liquidation
price closer at the same time.

Coin-margined products can be helpful in hedging directional exposure to the downside, but
their non-linearity can quickly become a problem if you’re long and wrong.

If you don’t have a clear understanding of the convexity of these products, it’s best to stay away
from them given that margin and PnL calculations are less straightforward than using linear
futures.

If you’re interested in learning more on this topic, read this and this.

Reasonable Use Cases for Leverage

Trading leveraged products gets an undeservedly bad reputation.

This is not because the products themselves are shitty. They’re not.

For the most part, especially when it comes to futures and perpetual swaps, they are very liquid,
cheaper to trade than spot, great for hedging, and allow you to express views on instruments
that you don’t have to own, among other benefits.
The reason for their bad reputation is because it is very easy for less informed participants to
use them to make bad decisions.

Specifically, as mentioned, the main way in which uninformed participants use leverage is to
make highly leveraged directional bets without an edge, most often resulting in liquidation.

It’s an inherently losing game.

That misuse of a tool doesn’t mean the tool itself can’t be used more productively.

Here are some examples.

Reducing Counterparty Risk

When you keep funds on an exchange, you’re trusting them to be responsible custodians of
your assets.

As we learned in the summer of 2022, that can be a mistake.

It is probably wise not to keep all of your assets in a single centralised exchange.

Leverage trading is useful in this regard because it allows you to effectively have access to your
trading portfolio without keeping all your trading funds in a single place.

For example, suppose you have $10000 USD to trade with.

Instead of keeping all $10000 on a single exchange, you can deposit a fraction of that amount
but still trade $10000 by using leverage e.g. depositing $5000 and trading at 2x leverage.

This reduces the likelihood of getting completely wiped out even if one of the exchanges of your
choice loses your money.

Hedging

Hedging is a broad term that implies a form of risk reduction, usually by taking the opposite
position to your existing position.

In this specific context, futures are good for hedging because you can manage the directional
exposure of your spot holdings without having to touch them.

For example, suppose you own 1 BTC in cold storage. You think the price will go down, but you
don’t want to sell that 1 physical BTC. Instead, you can use futures to short 1 BTC to protect
against downward price movement.
This can also be extended to staking, yield farming, reducing your overall directional exposure
without having to close your best positions, and so on.

Pair Trades

Leverage trading, specifically having access to a large range of futures products, is also useful
for pair trades.

Pair trading involves longing one pair which you’re bullish on while shorting (an equivalent
amount) of another pair which you think is weaker.

As a result, you neutralise the directional exposure to the broader market itself and your PnL is
dictated solely by the performance of those pairs relative to one another.

For example, suppose you think Polygon is strong and Ethereum is weak. You buy 1000
contracts of MATIC/USD and at the same time sell 1000 contracts of ETH/USD.

In doing so you’re effectively long MATIC/ETH.

If your view of relative strength is correct and the broader market goes up, you make money.

If your view of relative strength is correct and the broader market goes down, you still make
money.

Effectively, by creating and trading this synthetic pair, your only concern is the relative strength
between the pairs, and not the direction of the market itself.

Pair trades can also be good in the context of a basket trade e.g. if layer-1s or dog coins are
trendy, you can long the strong ones and short the weak ones and be exposed to that sector
without having to buy a bunch of stuff you wouldn’t want to hold for any meaningful period of
time.

The possibilities are endless, but the ability to create custom, synthetic pairs that limit your
exposure to the underlying direction of the market more broadly is extremely valuable and
underused.

Carry Trades

When the market is bullish, futures typically trade at a premium.

In those conditions, there is an outsized demand to be long and own crypto, and that demand is
reflected in the cost of holding bullish positioning (higher funding rates on perpetual swaps,
larger premia on futures, and so on).
Futures allow participants to capture that premium.

For example, if BTC/USD quarterly futures are trading at a 10% premium to BTC/USD spot, one
can buy spot, short the future, and capture that 10% premium (minus trading costs).

The same mechanism can be used for perpetual swaps when funding is high i.e. buy spot, short
futures, and collect the funding rate.

This trade is essentially arbitraging the difference between the price of crypto spot and the price
of crypto futures.

Overall, structurally, it’s a good way to capture yield in a bullish market with more limited
directional exposure.

Conclusion

Hopefully you learned something new.

As you can tell, it’s very easy to misuse leverage to make edgeless directional bets resulting in
liquidation.

That is the default experience for the average market participant.

We wrote this document as a concise, accessible guide to reduce the likelihood of that
happening to you.

As a reminder, if you learned something useful and to support this free resource, you may wish
to sign up to FTX via this link.

Or this one if you’re in the U.S.

If not, that’s cool too.

Thanks for reading!

P.S. Share this with a friend before they get liquidated (again).