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What Is Leverage and How Does It Relate to the Margin Trading?

Leverage is an important concept in trading. At the core, leverage means using borrowed funds to increase the potential return of an investment. In other words, put less of your own money but gain more. The term “margin trading” is essentially a strategy that involves leverage since you use margin to create leverage.

Leverage is usually expressed as a ratio between the amount of money you really have and the amount of money you can trade using borrowed money. For example, if you need only 100 USDT on your balance to make a 1,000 USDT trade, then it means you use a 1:10 or 10x leverage (1,000 / 100). 

If you know the leverage ratio, then you can easily find a margin requirement for trade and vice versa. For instance, 2% margin requirement is the same as 1:50 leverage (100% / 2%). So leverage has some kind of inverse relationship to margin. “Leverage” and “margin” are similar and refer to the same concept but from a slightly different angle. 

Let’s dive into the mechanics of leverage. The hypothetical example below shows how it works: what happens when the price does move in the desired direction and when it does not.

Inputs:

Let’s say you think that the Bitcoin price will go up and you have $1,000 on your balance. Since you believe that the price should go up, you want to open a Long Position. BTC price is $50,000 and you want to open a position of 0.1 BTC worth ($5,000). In this case, you can use a 1:5 or 5x leverage to get your position worth $5,000. Your $1,000 remains locked on the platform as collateral until you decide to stop trading.

Scenario 1: the BTC price reaches $55,000

You close the position with a gain of $500 ((55,000 – 50,000) * 0.1).

The borrowed funds return to the broker. Your $1,000 is returned to you as well. So now you have $1,500 (1,000 + 500) in your balance.

That’s a whopping 50% return on your investment: $500 / $1,000 = 50%!

If you haven’t used 1:5 leverage in this scenario, then you could buy 0.02 BTC with your $1,000. If the price reached $55,000, you would sell your 0.02 BTC for $1,100, getting a $100 gain (1,100 – 1,000). The return on your investment would be 10% (100 / 1,000).

No coincidence that with 1:5 leverage and price movement in your direction, the return is 5 times higher than without leverage.

Scenario 2: Price drops down to $45,000

You close the position with a loss of $500 ((45,000 – 50,000) * 0.1).

So you’d cover this $500 loss with your collateral, which was locked before trading. As a result, you will have only $500 (1,000 – 500) left in your collateral, which gets returned back to you. In other words, your initial collateral of $1,000 diminishes by the amount of your $500 loss.

So your negative return on investment is minus 50% (- 500 / 1,000)!

If you haven’t used leverage, then your negative return on investment could be 5 times less as in the first scenario (50% / 5 = 10%)

Just as leverage amplifies your gains, when the price moves in a favorable direction, it also does the same with your losses. If the price does not move in the direction you wish, your losses are much higher with leverage than without.

Note that the example shows you what happens under the hood for a better understanding of margin trading. In practice, your profit and loss (FPL – floating profit & loss) will reflect the movements of price so you can see how much your balance will grow or diminish if you close a position.

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