The cryptocurrency market is growing extremely fast. In the past few years, not only have new cryptocurrency projects emerged, but the range of investment opportunities has grown significantly. Although HODL is still the most popular investment strategy in the world of cryptocurrencies, more and more attention is drawn to other tools and derivatives that are probably entering the markets of decentralized assets. One of the instruments that are increasingly used in the cryptocurrency market is financial leverage.
In this article, we will introduce you to what leverage is and explain how it works. You will also learn how the financial leverage on BTC in Poland is developing.
What is Leverage?
Financial leverage is a direct impact of the capital structure, and consequently financial costs (interest on loans and borrowings – i.e. the cost of foreign capital), on the efficiency of using equity, measured by the return on equity – ROE “- Wikipedia
The above encyclopedic and financial definition of leverage can seem a bit overwhelming. This tool is not only used in cryptocurrency markets. Leverage is an important tool in corporate finance and applies to financing investments with foreign capital. For the purposes of the discussed issue, we have prepared a slightly simplified interpretation:
Financial leverage is the use of borrowed funds to finance the purchase of an asset (e.g. Bitcoin), assuming that the return or interest on the investment in the good exceeds the cost of the loan.
In most cases, the debt provider sets a limit on how much risk he is willing to take. This is how the leverage limit is determined. In the case of asset-backed loans, the financial institution uses the assets as collateral until the borrower repays the loan. In the case of a flow-through loan, the company’s overall creditworthiness is used to repay the loan.
How does leverage work?
Leverage works by using a margin, which gives us increased exposure for a given investment. In practice, we only use a part of our investment capital, and the broker / lender covers the rest of the necessary amount. This solution allows you to limit the use of equity capital during the investment.
The amount of the required financial deposit is determined by the leverage ratio – it shows what part of the total investment is paid by the user in the form of a security deposit. This works as shown in the example below.
Let’s look at a concrete example of how leverage works in the stock market.
Trading BTC / USD
Suppose you want to buy 10 BTC for $ 10,000 apiece. In order to be able to create such a position with the help of a traditional exchange, you would have to allocate capital worth $ 100,000 (ignore commissions and fees). If the price of Bitcoin increases by 5% after the transaction, your profit will be $ 500 for each Bitcoin you have. Thus, you will earn $ 5,000 on your $ 100,000 investment.
Leverage 1: 100
Again, let’s say you want to buy 10 BTC for $ 10,000 each. With a leverage of 1: 100 (margin to debt financing) you only need to pay 1% of your total position ($ 100,000). Your contribution will then be $ 1000. If the Bitcoin price rises by 5%, you will again earn $ 5,000 on your investment – this time, however, your costs will be $ 1,000 due to the lower value of the margin involved.
Leverage is a tool that allows you to get high profits with relatively low capital expenditure. However, be aware that the use of leverage carries a high level of risk. If your investment fails, you may lose your entire deposit. And even receive an overdraft on our account – we will then be forced to cover the losses incurred by the broker.
Leverage on the stock exchange
Today, more and more entities in the cryptocurrency market are offering margin trading within their platforms. These platforms also use different levels of leverage. One of the largest and most popular platforms in the world that offers margin trading is BitMEX. Recently, however, this platform has been struggling with many legal problems (mainly related to KYC). Moreover, it is considered to be a very advanced tool – it requires detailed familiarization with the functioning mechanisms.
The leverage mechanism on BTC is also developing in Poland. An example is the dynamically developing Geco.one platform. This simple and user-friendly platform boasts a turnover of over a billion dollars, and the leverage mechanism in the ratio of 1: 100 is available for all listed cryptocurrencies. Also, Geco.one gives a guarantee of protection against the negative balance of our account (our loss will not exceed the amount of the security deposit).