The Hard Truths of Crypto Leverage Trading

With leverage, traders can control much larger positions than they could using only their own capital. For example, a trader with $1,000 could control a $10,000 position if they use 10:1 leverage provided by the trading platform or brokerage.

While leverage can amplify gains, it also dramatically amplifies losses if the trade moves against the trader. This is why leverage is considered an extremely risky strategy, especially for volatile assets like cryptocurrencies. A relatively small adverse price move can wipe out the trader’s entire capital when high leverage is used.

In this article, I will analyze the main risks of crypto leverage trading through real-world examples and data. My goal is to demonstrate why using leverage is more likely to destroy capital than generate enduring profits when trading volatile digital assets.

Key Risks of Crypto Leverage Trading

There are several interrelated factors that make leverage trading particularly dangerous in the cryptocurrency markets:

1. Extreme volatility - Crypto prices fluctuate much more violently than stocks and forex, resulting in frequent and sizable margin calls and liquidations with leverage.

2. High funding rates - Traders pay very high financing fees to keep leveraged positions open during periods of market volatility. These funding payments steadily erode equity.

3. 24/7 markets - Cryptocurrency markets are open 24 hours a day, 7 days a week, with often large overnight price gaps that can trigger margin calls.

4. Flash crashes - Occasional flash crashes liquidate huge numbers of leveraged longs and shorts very rapidly as cascading stop losses are triggered.

5. Temporary bans - Exchanges sometimes ban leverage trading during periods of extreme volatility, forcibly closing positions at adverse prices for traders.

In the sections below, I will look at historical examples of each of these high-risk factors impacting leveraged crypto traders and forcing losses.

Example 1: Extreme Volatility Liquidations

Cryptocurrencies are infamous for their volatility compared to other asset classes. For example, Bitcoin has historically seen daily price swings between 5-10x greater than the Nasdaq 100 stocks or gold.

Such huge daily price moves are manageable for investors with no leverage. But they frequently create margin calls and liquidations for traders using leverage.

For example, between June 13 and June 15, 2022, Bitcoin plunged 30% from $29,000 to below $20,000. This was Bitcoin’s worst 2-day drop since March 2020.

Many Bitcoin long positions on exchanges like Binance with 5x or greater leverage would have seen margin calls and been liquidated during this brief collapse. The leverage would have amplified losses by 5 times or more compared to holding the underlying Bitcoin with no leverage.

Some altcoins saw even more violent sell-offs during that period, with names like Solana and Dogecoin plummeting over 50% in the span of 48 hours. Losses were dramatically multiplied with leverage.

Crucially, traders have no way to know beforehand when or if a sudden and steep crash might occur. Holding leveraged long positions through such declines results in getting liquidated with huge losses. Going short with leverage during speculative rallies has the same outcome.

Example 2: Punitive Funding Rate Payments

Exchanges charge leveraged traders periodic funding fees to keep their positions open when markets have sharp directional moves. These funding rates are similar to interest payments charged on borrowed capital.

During the 2021 bull market, Bitcoin funding rates frequently spiked over 10% per week on derivatives exchanges like Binance for traders going short with leverage. Traders attempting to short-sell Bitcoin through its surge to nearly $70,000 were paying severely punitive fees just to keep their trades open day after day.

For example, if Bitcoin rallied 50% higher over a multi-week period with a funding rate of 10% charged daily, short positions would face cumulative funding fees equal to 35% of position size or higher.

These arcane funding rates routinely reach extreme highs during crypto bubbles and crashes but are not faced by investors with no leverage. Paying 10-50% every week in borrowing fees is unfeasible, rapidly draining trading capital.

Example 3: Overnight Gaps & 24/7 Markets

Another danger stems from the fact that, unlike the stock market, cryptocurrency markets operate 24/7 with no downtime. Prices can fluctuate sharply at all hours.

Significant overnight price gaps are common in crypto markets after major news events. These gaps occur while the trader is asleep creating enhanced risk with leverage.

For example, when Elon Musk announced in May 2021 that Tesla would no longer accept Bitcoin payments, Bitcoin plunged from $55,000 to below $49,000 within minutes. Traders woke up the next day to find 6%+ price gaps going against their leveraged positions as losses mounted.

The week after Musk’s tweet, Bitcoin fell a further 25% to near $40,000 as leveraged longs capitulated. Holding 3-5x leverage long positions through this decline would have resulted in getting liquidated with 15-25%+ losses from the overnight gaps and subsequent sell-off.

Major crypto price moves can happen at any hour. Traders using leverage awake to uncomfortable margin calls and liquidations from overnight volatility they cannot directly monitor or respond to while sleeping.

Example 4: Flash Crash Liquidations

Occasionally, crises of confidence combined with cascading liquidations create a vicious cycle leading to a flash crash in crypto markets. These crashes result in forced liquidations and tremendous slippage for leveraged traders.

The most extreme example occurred on May 19, 2021, when Bitcoin plunged 30% within minutes after failing to break above $40,000. Over $10 billion worth of leveraged positions were wiped out during this event.

The crash was initially triggered by spooked retail traders and investors rushing to sell Bitcoin to realize profits after its rally back towards previous all-time highs stalled.

As prices began dropping, automatic liquidations kicked in on exchanges when leveraged long positions couldn’t meet margin requirements. This resulted in forced market sell orders as traders were closed out of their busted leveraged trades.

With so many traders using excessive leverage at the time, liquidations ended up pushing Bitcoin off a cliff as they triggered further stop losses and panic selling.

Leveraged shorts also faced liquidations as Bitcoin swiftly recovered half its losses that same day after support emerged around $30,000. Traders using leverage ended up getting harmed on both the way down and on the partial rebound.

Ultimately, hundreds of millions in positions were liquidated across cryptocurrency exchanges during the flash crash event. Analysis showed 20x leverage long traders lost essentially everything, with shorter timeframes and higher leverage resulting in greater destruction of capital.

Key Takeaways & Lessons

The above real-world examples demonstrate why using leverage is generally incompatible with the realities of cryptocurrency market structure. Traders attracted to leverage for its profit potential need to be aware of these systemic risks:

• Extreme volatility results in frequent liquidations with leverage that amplifies losses

• High funding rates steadily erode equity making leverage expensive to maintain

• Overnight gaps create outsized risks with margin calls from 24/7 price action

• Flash crashes periodically wipe out huge numbers of leveraged positions

• Forced closures and restrictions generate slippage and unplanned exits

A key lesson is that unexpected and violent moves resulting in leveraged losses can come at any time in the crypto markets. Declines often start from all-time high prices that lured traders.

No trader can consistently predict when or which direction these trend-ending moves will occur. Using leverage in crypto almost guarantees getting caught on the wrong side of sudden reversals and events.

The above examples saw long traders get burned by collapses from market tops and short traders get hurt trying to predict bottoms. Any leveraged position is at risk of liquidation with little warning.

Even experienced traders can get repeatedly damaged trying to navigate crypto’s volatility on leverage. Bubbles, blow-off tops, capitulation events, and recovery rallies routinely catch overly aggressive positioning off guard.

A look at historical drawdowns shows Bitcoin and Ethereum each having five 70%+ declines after new market cycle highs during the 2010s. Traders using more than 3-5x leverage would get totally wiped out multiple times over, having to restart trading capital from zero.

In summary, while leverage may occasionally result in a windfall profit from correctly guessing the magnitude and timing of a cryptocurrency’s next major price swing, odds of repeat success are low. Leverage effectively gambles with probabilities skewed heavily against traders given crypto’s fundamentals.

Events occur suddenly that instantly change market conditions and trends, creating adverse, margin call-inducing volatility across cryptocurrencies. Traders have consistently found leveraged profits from cryptocurrencies ephemeral at best and entirely fleeting at worst once the next inevitable reversal hits.

Sticking to no leverage with a long-term buy-and-hold investment approach or trading moderate positions without leverage tends to be far more profitable and consistent than gambling with borrowed funds.

Serious traders need to consider whether temporary wins using leverage outweigh the dictated risk of ruin from inevitable & potentially fatal margin calls. The data shows leveraged trading heuristics failing over complete crypto market cycles.

Based on crypto’s historical volatility patterns across assets, events, regulations, and market structure – the risks and consistent losses seen from using leverage are likely to persist over the coming decade rather than abate.

If you enjoyed this article, please read my previous articles

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The Path to Writing Mastery: A Practical Guide for Blog Writing
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