Steemit Crypto Academy Contest / S13W6 - Leverage in cryptocurrencies

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INTRODUCTION

Greetings friends and welcome to the last week of engagement for this 13th season. This week we discuss the topic Leverage in cryptocurrency. So let's learn about leverage in the cryptocurrency. But then, have you ever borrow money to start up a business? If yes, then you have an idea of the topic at hand.

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In your own words, what do you understand by leverage?

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Leverage in its literal meaning refers to using something to gain an advantage or achieve a desired outcome. Like using tools to help us finish work on time.

For example, I want to lift a heavy object, but instead of trying to lift it with my strength, I use a tool (lever) to help me lift the object using less strength than the one I would have used using my strength. Therefore, the lever enabled me to leverage my strength and made the task easier for me.

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A Lever in simple machines is merely a long, rigid object one can use to lift or move objects. Levers usually have a fulcrum acting as a pivot point, where a user applies force at one end to cause an action at the other end, helping users to lift heavy objects with less effort. A good and common example is the seesaw or a crowbar.

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Now, this is also applicable to cryptocurrencies, since the topic of discussion is centred around cryptocurrency.

In the world of cryptocurrencies, leverage can be referred to as borrowed funds to boost one's potential gains (or losses) on investments, going by the literal meaning, to gain advantage. Thus, leverage is about using borrowed money to trade or invest in cryptocurrencies.

For example, Let's say I have $100, but I want to make a larger trade, which I can't afford on my own. However with leverage, I am allowed to borrow additional funds, let's say $900, to have a total of $1,000 to invest.

Now, If my investment goes up by let's say 10%, I would make a profit of $100 instead of just $10. By doing so, I have successfully used the leverage system to gain $90 more. However, it's important to know that it can go both ways, profit or loss.

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Explain how leverage works

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If you don't mind, I would like to draw our attention to how the lever system in simple machines works, and then draw similarities to the cryptocurrency market.

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The image above shows a lever with a load (F1) and distance (D1) from the fulcrum on one end, and on the other end is a force (F2) and Distance (D2). Now, what happens is this, F2 is applied to lift F1, Merely looking at the image, we can see that F1 is way heavier than F2, but F2 still lifts F1, why?

This is where the Distances D1 and D2 come in, D1 is the distance between the Fulcrum and the Load (F1), whereas D2 is the distance between the fulcrum and the Effort (F2).

We can see that the distance D2 is longer from the fulcrum, this is because the longer the distance (D2) of Effort (F2) from the fulcrum, the less energy it requires to lift the Load (F1). Hence, the distance (D2) from the fulcrum to Effort (F2) is what we refer to as leverage.

This is similar to how leverage works in the cryptocurrency market, however, the distance is replaced by percentages or ratios, where the higher the ratio or percentage the higher the potential return.

For example, I want to buy Bitcoin but have only $1,000. Hence, with leverage, let's say leverage of 10:1 or 10x, I can borrow 10x more of my capital, which means that I can borrow up to $10,000, making a total investment of $11,000.

From;
$1,000 + $ (10 x 1,000) = $1,000 + $ 10,000 = $11,000.

Now, after using the $11,000, to buy Bitcoin, if the price of Bitcoin increases, I stand the chance of earning a bigger profit compared to buying the Bitcoin with my $1,000.

For clarity purposes, let's assume the price of Bitcoin rises by 10%, I would have earned $1,100.

From;

Profit = ∆% x Investment

Profit = 10% x $11,000 = (10/100) x 11,000 = 0.1 x $11,000 = $1,100

Therefore, resulting in a 100% return on my $1,000 after removing the interest paid on the loan.

From;

Loan interest = % of leverage x principal

Loan interest = 10% of 1,000 = 0.1 x $1,000 = 100.

Net profit = $1,100 - $100 = $1,000

A 100% profit from my initial $1,000

But this would not be possible without the leverage, as without the leverage, I would have earned just $100.

From;

Profit = ∆% x Investment

Profit = 10% x $1,000 = (10/100) x 1,000 = 0.1 x $1,000 = $100

But then, leverage also magnifies losses as it does to profits. So let's say if the price of Bitcoin drops by 10%, I would have lost $1,100, or a 110% loss of my initial investment, leading to a debt of $100.

From;
110% x $1,000 = (110/100) x $1,000
= 1.1 x $1,000 = $1,100

whereas, I had only $1,000, therefore $1,000 - $1,100 = - $100 debt (loan interest)

However, without the leverage, I would have only lost $100 of my investment. As shown below;

Loss = ∆% x Investment

Loss = 10% x $1,000 = (10/100) x 1,000
Loss = 0.1 x $1,000 = $100

This is how the leverage strategy works in any financial or crypto market.

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Why is leverage used in cryptocurrencies?

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Leverage is used in cryptocurrencies and other financial markets for the following reasons;

To Increase Profit:

Leverage is used by traders to increase potential earnings resulting in bigger profits if the position favours them, as leverage allows traders to carry out larger trade positions with less initial capital.

Increased Trading Opportunities:

Leverage provides the opportunity for traders to take advantage of the short-term movements of prices. Hence, it enables traders to open larger positions and potentially profit from even the smallest price changes.

Diversification:

Leverage allows traders to diversify their portfolios by spreading their investments across multiple assets, providing them the chance to take part in different markets and potentially benefit from various price movements.

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If you want to open a long position and you have 12,000 USDT in Steem and a leverage of 10x. Explain if the price of Steem rises by 45% and then explain if the price drops by 15%. Give your own opinion.

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Okay, let us assume I have 12,000 USDT in STEEM and I'm given a leverage of 10x. This means I can control a position size of 120,000 USDT from, 12,000 USDT x 10. Below are the possible outcomes or how it would work if I open a long position on STEEM.

For the 45% Rise

If the price of STEEM rises by 45%, I would gain 45% x 120,000 USDT = 54,000 USDT.

From;

PROFIT/LOSS = ∆% X INVESTMENT

Where;
Profit = 45% x 120,000 USDT
Profit = (45/100) x 120,000 USDT
Profit = 0.45 x 120,000 USDT
Profit = 54,000 USDT

Therefore, I would have made a net profit of 39,600 USDT.

From;

Net Profit = Profit - (initial investment + loan interest)

where;
loan interest = initial investment x % of leverage.

Therefore;
Net profit = 54,000 USDT - (12,000 USDT + (12,000 USDT x 0.1)) = 39,600 USDT.

Which is a 330% return on investment (ROI), that is a 330% profit, from;

ROI = ((Net Profit or Loss) / Investment) x 100

Therefore,
ROI = (39,600 USDT / 12,000 USDT) x 100
= 3.3 x 100 = 330%.

For the 15% Drop

If the price of STEEM drops by 15%, I would have a loss of 18,000 USDT. From;

PROFIT/LOSS = ∆% X INVESTMENT

where;
Loss = 15% x 120,000 USDT
Loss = (15/100) x 120,000 USDT
Loss = 0.15 x 120,000 USDT
Loss = 18,000 USDT.

Therefore, I would have incurred a loss of 31,200 USDT, from:

Net Loss = Loss + (initial investment + loan interest)

where;
loan interest = initial investment X % of leverage.

Therefore;
Net loss = 18,000 USDT + (12,000 USDT + (12,000 USDT x 0.1)) = 31,200 USDT.

Which is a -260% return on investment, that is a 260% loss, from;

ROI = ((Net Profit or Loss) / Investment) x 100

Where;
ROI = (31,200 USDT / 12,000 USDT) x 100
= 2.6 x 100 = 260%

In my opinion, using leverage can increase a trader's profits in a short time, but it also exposes the trader to higher risks and increases potential losses if the price moves against him. Therefore, using leverage can be somewhat risky.

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Mention the advantages and disadvantages of leverage.

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Advantages of leverage

Amplified Profits:

Leverage creates an opportunity for traders to potentially make larger profits by magnifying the gains on their investments, as it allows traders to control a bigger position with a small amount of money.

Increased Trading Power:

Using leverage helps traders increase their trading power, giving them the chance to have more buying power than they could have had using their investments thereby giving them the power to trade larger amounts.

Diversification Opportunities:

Leverage allows traders to diversify their investments across different assets. Thereby, helping traders spread their risk across different assets, while also increasing their chances of earning profits from the various assets.

Increased buying power:

Leverage gives traders an increased buying power beyond their initial investment, allowing them to buy more assets than they would be able to with their capital alone.

Lower capital requirement:

Leverage provides support for traders to enter the market with even smaller capital than would be needed to trade assets, making it more convenient for individual traders.

Disadvantages of leverage

Magnified Losses:

Just as leverage can amplify traders' gains, it can also do so for their losses. This happens when the market moves against their positions, it can result in losses even bigger than their initial investment, as I've shown in my first example, where the trader ended up owing $100.

Increased Risk:

Leverage involves taking on additional risk, as much as it provides opportunities for higher returns, it also comes with a higher level of risk where market volatility can lead to significant losses.

Margin Calls:

When using leverage, traders need to maintain a certain level of funds in their accounts, this is known as "margin". This comes in handy when the position moves against the trader and the account balance falls below the required margin, then, the trader may receive a margin call and be required to add more funds or close his/her position.

Risk of blowouts:

This means that leverage can result in the complete loss of a trader's investment in a particular trade or, worse, leaving the trader with a negative balance in their account.

Psychological aspects:

With leverage trading, a trader may be tempted to enter trade positions with higher leverage hoping to make a quick profit, which in turn also increases the risk.

CONCLUSION

In conclusion, Leverage is a double-edged sword because as much as leverage has the potential to magnify returns, it also amplifies the risks. Therefore, traders should use it cautiously as part of a risk-controlled strategy.

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I wish to invite @starrchris, @yancar, @ngoenyi and @suboohi

Thank You for your Time

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NOTE: Always have a smile on your face, as you are never fully dressed without one.